Lot of people ask questions regarding bonus shares and stock splits. There is lot of confusion among many investors. As both stock split and bonus shares results in increase in quantity of stocks and adjustment of share price many don’t understand the difference between them. Lets us try to understand whats the difference between them with an example.
Lets take a dummy company name xyz whose stock is trading at 50 Rs. The share has face value of 10 and the number of outstanding shares are 10,000 and it has 2,00,000 Rs in reserve which it has accumulated by saving its profits. To summarize
- Stock price: 50
Stocks outstanding: 10,000
Face value: 10
- Market capital:50×10,000 = 50,0,000
Company issues bonus shares
A company can reward its investors either through dividends or through bonus shares. The company pays for dividend or bonus shares through the reserve cash. Issuing bonus shares takes out more money from the reserve than dividends. Generally a company issues bonus shares to increase liquidity. When the stock price increase too much it becomes expensive for many small investors. Giving bonus shares increase the number of outstanding shares and reduces the price that makes it more affordable for small retail investors. Issuing of bonus shares also increases the confidence of investors in the company as its rewarding them.
Lets assume that the company xyz issues bonus shares. The company uses the reserve cash of 2,00,000 and creates additional 10,000 of same face value 10. It distributes these shares to existing shareholders in the ratio 1:1 . This will increase the number of outstanding shares to 20,000
Market capital is the function of the profit of the company. Issuing of extra share doesn’t have any effect on the profit of the company. Therefore to keep the market capital same the share price is adjusted. The market capitalization of 10,000 shares at the price of 50 was 5,00,000 it will remain the same after additional shares also. Hence the new price of the stock will be 500000/20000 = 25 Rs. Therefore after the issue of 1:1 bonus shares things will become like this
- Stock price: 25
Stocks outstanding: 20,000
Face value: 10
- Market capital: 25×20,000 = 5 00000
You can notice there was change in the stock price, number of outstanding shares and reserve balance. Market capital remains the same.
Company splits the stock
Stock split is same like cutting an eight-inch pizza into 12 slices from four slices before. In a stock split, fundamentals about the company does not change, the issued share capital remains the same, the revenue remains the same, and the profit remain the same too. The face value gets changed. If the same company xyz goes for stock split from the face value of 10 to the face value of 5. The number of stocks will get double and the price will get adjusted to half.
Difference Between Stock split and bonus shares
|After Split||After 1:1 bonus|
From the above table you can see that bonus share results in reduction of reserve capital which is used to create new shares. Stock split results in reduction of face value of stock.
Bonus share is considered more positive because it shows that company is confident of more earning in the future, that’s why it can afford to issue more shares for free to investors by reducing its reserve capital. To know what wonders stock split can do for long term investors check this bonus flow of infosys.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.