Stock split vs bonus issue: Know the difference

What is a stock split?

Imagine that you have a chocolate bar. Now, split this chocolate bar into two equal parts. What do you notice?

You still have the same amount of chocolate with you. 

The only difference is that you now have two smaller bars instead of one big bar. That is a stock split for you.

In financial terms, a stock split is an action wherein the issuing company splits the existing shares into multiple shares. The end result does not change the company’s market cap, but the share price gets divided.

Below is an example to help you understand the effect of a stock split.

Let’s say you currently have 100 shares of a company, with each stock’s market price being Rs. 200. Now, if the stock split is announced in a 4 to 1 ratio, each stock would be split into four parts. This means you now have 400 shares. At the same time, the price of the stock gets divided by a factor of 4. Below is a tabular representation to summarise the example.

By now, you must have noticed that although the price and total number of shares changed, the total investment value remains the same. Guess the chocolate example is making much more sense, right? 

Why do companies issue a stock split?

You might wonder, if the company’s total market cap remains constant, why do companies opt for a stock split? The reason is pretty simple: to control the prices of the stock.

A stock split is usually done when the price of the stock is too high. By splitting the stocks, they become more affordable to investors, and at the same time, with an increase in the number of stocks circulating in the market, the liquidity of the stocks also increases.

In this way, all these companies are solving two problems with one solution.

What is a bonus issue?

It is time to explore what bonus shares are using the same chocolate analogy. In this scenario, let’s say you are purchasing a bar of chocolate that costs Rs. 100 at a shop with an offer that says, “buy one and get one free if you are a regular customer”. 

Here, each chocolate costs you Rs 50 rupees. This is the same as a bonus issue. 

When a bonus issue occurs, the shareholders receive bonus shares in some ratio to the existing shares. In essence, the accumulated earnings or the reserves of the company are converted into equity shares when bonus shares are issued. The share capital of the company increases while the reserves decrease.

Similar to a stock split, a bonus issue does not affect the market cap but reduces the stock price to the same ratio as the bonus issue.

Below is another example to clearly explain the impact of a bonus issue in terms of numbers. The table below explains the impact on shares when a 3:1 bonus ratio is issued.

Why companies issue bonus shares?

Bonus shares act as an alternative to issuing dividends to the company’s shareholders. Apart from this, bonus shares are also useful in encouraging retail participation.

Wondering how? Well, as you already know, issuing a bonus causes the share prices to go down but increases the value of the company in the eyes of shareholders as the company tries to share its success with customers. This makes it appealing to investors.

Finally, the liquidity of the stocks increases, which again increases the ease of entering and exiting the market, prompting investors to buy the company’s shares.

Bonus share vs stock split: What is the difference?

Here is a table to understand the difference between stock split and bonus.

Advantages and disadvantages of stock split

With the basics of stock split under your belt, it is time to explore the benefits and drawbacks of these decisions by the company.

Advantages

1. Share affordability: The company’s stocks become more accessible as well as affordable due to a decrease in price and an increase in the number of shares. This attracts new investors, leading to an increased demand, which may drive up the price and increase the returns.
2. Increased liquidity: Due to improved liquidity, it is easier for you to buy and sell shares as a stock split attracts more investors to enter the market.

Disadvantages

1. Negative perception: Sometimes, a split is seen as a sign of financial challenges in the company, which creates a negative impact on both the market sentiments as well as the stock prices, which may potentially reduce the returns or result in losses.
2. Trigger volatility: The volatility of the stocks increases as they are now traded in large volumes due to prices of the stock being lowered.

Advantages and disadvantages of bonus issue

Time to find out how a bonus issue would affect you as an investor and the different advantages and disadvantages that are associated with it.

Advantages

1. Increased liquidity: The liquidity improves due to the increased number of investors in the market, making it easier for you to enter or exit market positions.
2. Future prospects: In the long term, these shares are beneficial in multiplying your investment value.

Disadvantages

1. Reduced earnings per share: A bonus share issue means that the number of outstanding shares in the market increases while the market cap remains the same, and this leads to a decrease in the earnings per share.
2. Reduced dividends: Unless the company increases its total dividend payout, the dividends that you receive per share decrease.

Conclusion

Hopefully, you now understand the concepts as well as the difference between stock split and bonus in a better way. While there is no increase in the market value or your total ownership of the company, a stock split and bonus may prove lucrative in the context of long-term investments. To find out more about the world of stocks, you can always head to our StockGro website!

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