What is the difference between bonus and stock split?

If you have been in the stock markets for some time, you would have by now heard the famous story of how Wipro could have made you a dollar millionaire many times over in the last 38 years. That is, of course, assuming that you resisted the temptation of investing Rs10,000 in buying a Bajaj Scooter in 1980 and had bought 100 Wipro shares instead.

After 11 bonus and 2 stop splits Rs10,000 becomes Rs505 crore in 38 years

Year Bonus / Split Ratio of Bonus / Split Year Beginning shares Year Ending shares
1980 - - 0 100 shares (Bought )
Up to 2018 After 11 bonuses After 2 stock split 1,92,00,000 1,92,00,000

After 11 bonus and 2 stop splits – Rs10,000 becomes Rs505 crore in 38 years

By now you are really confused. Did the bonus issues create the wealth or was it created by stock splits? The answer is “Neither”. Both bonuses and splits are value neutral and it is the financial performance of Wipro over the years that has helped create wealth. What bonuses and splits have done is to keep the stock price of Wipro within an acceptable range so as to elicit investor interest.

What is a bonus and what is a stock split?

Both bonus and splits entail a small tweaking of your capital base. In case of bonus, the company issues fresh shares to the existing shareholders by capitalizing the profits held in the free reserves of the company. In case of stock split, just the par value (fair value) of the stock gets reduced proportionately. Let us look at this with a live case.

Bonus Issue Details Stock Split Details
Share Capital(25 lakh share of Rs10 each) Rs2.50cr Share Capital(25 lakh shares of Rs10 each) Rs2.50cr
Reserves Rs5.00cr Reserves Rs5.00cr
Total Equity Rs7.50cr Total Equity Rs7.50cr
Bonus Ratio 1:1 Stock Split Rs10 to Rs5

What happens after the bonus and the split?

Rs2.50cr Share Capital (50 lakh shares of Rs.10 each) Rs5.00cr Share Capital (50 lakh shares of Rs5 each)
Reserves Rs2.50cr Reserves Rs5.00cr
Total Equity Rs7.50cr Total Equity Rs7.50cr

Let us look at the company's capital before and after the bonus issue. The share capital has increased but the reserves have reduced proportionately. Thus, the net worth of the company remains the same. In the case of stock split, the share capital and reserves have remained the same. Instead, the number of shares has doubled and the par value of the stock has halved. Just to cite a story, if Wipro were to handle the growth and value creation without stock splits and bonuses, then each stock of Wipro will be quoting at Rs5cr. Something that will surely make Berkshire Hathaway blush!

Why do companies go for a stock split?

A stock split is a subdivision of the par value of the share. For example, if the par value of Rs10 is sub-divided into par value of Rs5, then it is a 1:1 stock split. Stock split can be in different ratios. In case of 1:1 stock split, the number of shares will double since the par value has halved. Since the earnings of the company are now being divided across twice the number of shares the EPS will halve and the stock price will also nearly halve. Effectively, if you were holding 1,000 shares at Rs80, you will end up holding 2,000 shares at a price of Rs40. The net impact is neutral.

What could be the trigger for a split?

One of the reasons is to bring the stock within a more acceptable trading range. For example, a stock with a par value of Rs10 is trading at Rs2,600 in the stock exchange. If the par value of the stock is split from 10 to 2, then there is 5 times more liquidity available on the counter. At the same time, the stock price will come down to around Rs520 bringing it within a more acceptable range for retail investors.

When do companies prefer a bonus issue?

A bonus issue actually involves transferring funds from the reserves to the share capital of the company. Free reserves of the company include general reserves created out of profits and share premium accounts. Effectively, bonus entitlement is for existing shareholders and a company with large free reserves can look to reward shareholders by transferring funds from the free reserves to share capital. This is an internal transfer from reserves to share capital, so total equity remains the same. It is a way of rewarding shareholders with stock instead of through cash in a way that is value neutral. Bonuses are normally announced by companies sitting on substantial free reserves.

Three things you need to know about bonuses and splits

Firstly, a split and bonus result in an increase in the number of shares outstanding and proportionate reduction in the market price. The extent of impact depends on the ratio of the bonus/split. Secondly, a 1:1 bonus is the same as a 10 for 5 stock-split at least in terms of the net wealth effect to the shareholder. Lastly, neither the split nor the bonus will impact the total equity and therefore "Return on Equity" (ROE) and other valuation parameters will remain the same.

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