A common question among customers and investors alike is ‘How is the company’? A customer would answer the question based on the quality of its products, services and post-sales experience. However, investors dive into complex internal or market-linked parameters to analyse a company’s worth. Based on the parameters used to analyse a company’s profitability and growth potential, the answer could vary from person to person.
Although analytical parameters are fundamental for examining a company’s quality, some parameters prove redundant in creating any real value but are still widely used by companies and investors to understand its worth.
Two such widely used parameters that appear redundant in creating any value for the company are Bonus Issue and Stock Split.
What is a Bonus Issue and Stock Split?
A Bonus Issue is when the company’s existing shareholders get extra shares for free in a particular proportion. For example, if a company issues 2:1 bonus shares, the shareholders will receive two shares for every share they hold. Furthermore, when the company announces a Stock Split, the existing shares are divided within themselves. Therefore, if the stock split is a 2:1 ratio, the number of shares doubles up.
Though the thought of having more shares for free sounds intriguing, in reality, the process of Bonus Issue and Stock Split do not create any real value for the company and the investors.
Why are Bonus Issues and Stock Split redundant?
Suppose you have a Rs. 500 note in your left pocket and another Rs. 500 note in your right pocket, and you decide to move both the notes to the right pocket. Now, in your right pocket, you have Rs. 1000, and in your left pocket, you have Rs 0. At this point, your overall value remains the same. The same is the case with bonus shares.
There are two types of capital:
- Issued and paid-up capital: The capital contributed by investors/raised by companies on the issuance of shares – no. of outstanding shares multiplied by face value per share
- Reserves and surplus: The contributed capital by investors in terms of share premium + retained capital (accumulated profits fully or partly retained by the business over the period of time).
Both these put together, form the net-worth of the company and fundamentally belong to the shareholders. When companies issue bonus shares, they move a part or full of their ‘reserves and surplus’ to the issued capital. It is called the capitalization of reserves. It is essentially a book entry wherein reserves go down, and fresh shares are issued to the existing shareholders in proportion to their holdings. It means moving money from one account (called ‘reserves and surplus’) to the ‘capital account’.
Although it increases the number of shares with the shareholders, it changes nothing in the Profit and Loss Account of the company. In the Balance sheet, the only change is the number of shares going up as issued capital increases and ‘reserves and surplus’ goes down. However, net-worth remains the same.
Suppose you have a note of Rs. 500 or 5 notes of Rs. 100 each. Is there a difference in the value of your holding? No. The same is the case with Stock Split. When a company splits the share of Rs. 10 face value into 5 shares of Rs. 2 each or 10 shares of Rs. 1 each, face value per share goes down, along with the book value per share and Earning per share. However, the share capital, reserves and net worth of the company remain the same.
Similar to Bonus Shares, nothing changes in the company’s Profit and Loss Account. There is no change in the Balance sheet as well other than the increase in the number of shares and decrease in the face value per share.
Why do companies issue Bonus Shares and Stock Splits?
The answer lies in psychology. In both cases, the number of shares with the shareholders go up. As the outstanding shares increase, the share price decreases, making the shares look cheaper and accessible to the investors. As it is seen that most of the investors, having less knowledge of the crucial parameters, chase price without understanding the value, companies prefer to keep their stocks cheap to make them look attractive. Companies believe that with a larger number of shares under the investor’s belt, their pocket seems heavier, thus creating a false impression of higher value.
Every company, big or small, wants as much attention from the investors as possible. As most investors generally accept Bonus Issue and Stock Split to analyse a business’ potential, companies tend to focus on embellishing them for the investors. Investors, too, get trapped in the psychological game where companies influence them by doing things that create no value.
Before analysing a company on any of the above criteria, you need to dive into their fundamental structure to ask yourself: ‘Should Bonus Shares or Stock Split really matter to you?’