Understanding Bonus Shares And Stock Splits & How They Affect Investors

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Bonus shares and stock splits are two measures taken by companies to reward their shareholders and increase the quantity of shares in the market. Both moves increase the holdings of people invested in a company without the need to pay anything extra for them. At the same time, these measures make stocks attractive for buyers.

Bonus shares and stock splits have different objectives though. Let’s take a closer look at why companies engage in them and how they affect investors.

Bonus shares

A bonus issue is also called a scrip issue or capitalisation issue. It involves issuing additional shares to current shareholders in proportion to their existing holdings from the net reserves of the company. When a company does not have enough cash to pay out dividends to shareholders, bonus shares may be issued as an alternative reward.

To explain in the form of an example: A person holding 100 shares in a company with a share price of Rs 300 has an investment value of Rs 30000. If a company issues a 2:1 bonus, the shareholder will get two extra shares for every share, taking the count to 300 shares (100 original and 200 bonus). The share price falls to Rs 100, while the investment value remains Rs 30000.

The effect of bonus shares

A bonus issue reduces the company’s net reserves and increases the issued share capital. The book value per share falls because the number of outstanding shares increases.

Upbeat market sentiment is usually associated with a bonus issue. Stocks of companies often jump as trader/investor interest surges. New investors are attracted as the stock becomes affordable and they see more value in it.

For existing shareholders, a bonus issue is a plus as they receive more shares sans added costs and tax (capital gains tax is only levied on selling at a gain). They can benefit from the increased liquidity a bonus issue affords and sell a portion of their holdings while still retaining some stake. 

While investors have the option of selling bonus shares immediately for a premium, they can also hold onto them for long-term benefits. Future dividend payments on a per-share basis include both purchased and bonus shares, which means shareholders can enjoy dividends on increased holdings.

Overall, a bonus issue unlocks more value from a stock for investors. The capitalisation of profit improves the company’s creditworthiness and position in the market, and if its fundamentals are sound, the stock can give good long-term returns to investors.

Stock splits

When a company’s stock price is too high, investors may find it difficult to purchase shares. The purpose of dividing a company’s share price—splitting its stocks—is to lower the price of a share to make it more appealing to investors and improve liquidity. A stock split breaks a share into more shares based on a proportion, and while the number of outstanding shares rises, the total value of all shares outstanding remains unchanged.

A company may perform a stock split if its stock price is perceived to be higher than that of its competitors and or the industry standard. The move effectively lowers the denomination of a stock, which investors may be more inclined to buy. 

For example, if a company performs a stock split of 1:2, one share becomes two. An investor holding 100 shares of Rs 100 each has an investment value of Rs 10000. After a 1:2 split, the investor now has 200 shares of Rs 50 each, with the investment value remaining the same.

The effect of stock splits

Like bonus shares, stock splits decrease the price per share, making it more affordable for new investors. Stock splits increase liquidity since there are more shares outstanding. This action usually sparks investor interest, leading to an increase in trading, and can positively impact the stock price.

Often the stock price reaches the pre-stock split level, making the company split its stock again. Many companies have split their stock multiple times over the years, and shareholders have been rewarded with an increasing stake without additional buys.

Stock splits are also considered an indication of executive confidence in a company’s prospects. Investors are bullish when a fundamentally strong company does a stock split as it’s a positive indicator of potential growth.

Bottom line

As investors look to delve into stocks that promise high long-term returns, it is natural for companies to make their stocks as attractive as possible for buyers. Bonus shares and stock splits, while not changing the investment’s market value, help investors discover value in stocks by making them more affordable. No wonder then, after bonus shares have been issued or stock has been split, stock prices often rise in a show of investor interest and higher demand for the stock.