Stock Split/Bonus Explained

This a a beginner’s guide to the stock market which advanced investors can safely skip.

What is a bonus issue?
This a mere book manipulation where a company increases the number of shares outstanding by giving a bonus share in a ratio called the bonus ratio and such an issue is called bonus issue.

What is a split?

Split is book entry wherein the face value of the share is altered to create more number of shares outstanding without calling for fresh capital or without altering the share capital account.
For example if a company announces a two-way split, it means that a share of the face value of Rs.10 is split into two shares of face value Rs.five each and a person holding one share now holds two shares.

Usually it is a much welcomed development and leads to a surge in the stock price. However, both of these are mere book manipulation the extra shares one gets due to these issues neither increase one’s holding in the company, change the company fundamentals, or create any extra wealth for the company.

Then why do the company does it:
1) To enhance liquidity:
Buying a stock is like carrying the currency notes. If you want to carry cash: you might not like to carry the entire amount in 1000/- bills for changing them for small bills would be cumbersome, nor you would like to carry then in 10p coins for that might mean lugging a sack around.
Similarly people often have reservations in investing in companies like Berkshire Hathaway because 136,500 USD per stock is much more than what many of us want to invest. nor do we want to invest in penny stocks… for it would be too cumbersome. Hence the companies come up with splits/bonus etc to modify the face value of the stock to keep it in the liquid range.

2) Tax Implications:
In India, tax on stocks is computed at the time of sale. So day traders often utilize this opportunity. They buy the stock before the record date and sell it the next day. So their book shows a loss on the difference in the price of the 2 shares + some shares (of the value equal to the loss) obtained at zero cost. This gives them tax breaks and is usually the reason why the prices surge before the split.

3) Generate PR:
There are over 800 stocks listed on the sensex and their numbers increase every day. So one of the best way for a medium size company to advertise itself and encourage people to invest/analyze its stock is to announce a split/bonus.

All said and done, the long term valuations/fundamentals of a company remain unaltered due to these cosmetic book changes. Hence an investor should not time his investment decisions based on a rumor/news of a split.