All icing, no cake: are bonuses and splits overrated?
Stocks often move up on announcement of a bonus issue or split. But does it make sense to invest in such a stock?
By Yash Rohra | Aug 16, 2019
A company's announcement of bonus shares or stock splits cheers its retail investors. But are these announcements actually favourable for investors? Although the company may promote bonus shares as free shares, the issuance of bonus shares is only an accounting entry where the company transfers the amount of additional shares from reserves (retained earnings) to the share capital account, leaving no impact on the company.
In the stock market, the value of a stock falls in proportion to the ratio of bonus issues. Similar is the case with stock splits, where the numbers of shares are divided in the ratio decided by the company and the price is adjusted proportionately.
We can compare both bonus issues and stock splits with a pizza, which is difficult to eat in one bite. But when it is cut into small pieces, it becomes easier to eat. Unlike stock splits, the face value of the stock remains the same in the case of bonus shares - the only differentiating factor between them. However, in no way do they impact the company's fundamentals.
Many investors buy a company's shares on the news of a stock split or a bonus issue, perceiving it to be a positive event. However, in reality, these events neither help the company raise capital from the market, nor do they add any value to the company. These sentiment-boosting corporate events are aimed at improving liquidity in the market and reducing the cost per share so that the stock becomes more affordable for investors. Besides, they do not indicate any bright future for the company. They may lead to short-term gains in some cases because of positive sentiment but in the long run, only the company's fundamental strength matters. So, investors should focus on the earnings potential and future growth of a company.
In 2008, when Reliance Power listed, it hardly had any revenues or profitability and thus, its stock nosedived within minutes of listing. Its listing price still continues to be its life high even after 11 years. Soon, owing to the depressed listing, the company went for bonus issue, which obviously infused some positive sentiment in the short run and sent the stock price high. As soon as the bonus euphoria died, the market looked at the company's weak fundamentals and the stock price again continued its downward journey. Anyone who invested in the stock at the time of bonus announcement is now sitting at an absolute loss of around 99 per cent.
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