Bonus vs Split limitations

Understanding Bonus Shares vs. Stock Splits

A common question in the world of investing is the difference between bonus shares and stock splits. Many people wonder whether one is better than the other. Both involve increasing the number of shares, but they differ in how this happens and what it means for the shareholder. Let’s take a closer look at both of these concepts to understand how they work and what their impact is on the stock price and your investment.

How Stock Splits Work

In a stock split, the number of shares increases by a certain ratio. For example, if a company has 10 lakh shares and announces a 1:2 split, the total shares will double to 20 lakh shares. This does not affect the overall value of the company, but it reduces the price per share. The company can continue splitting its shares until the face value reaches ₹1, which is the minimum allowed by Indian regulations. The starting face value of a share is usually ₹10, and after multiple splits, it may come down to ₹1.

What Happens During a Bonus Issue

A bonus issue, on the other hand, is an accounting transaction. In a bonus issue, the company moves money from its reserves into share capital. For example, if a company’s reserves are ₹5 crores and its share capital is ₹1 crore, a 1:1 bonus will double the share capital to ₹2 crores. The number of shares will also double, but the face value will not change. This is only possible if the company has enough reserves to issue the bonus. Like in a stock split, the price per share will decrease, but the face value remains the same.

Tax Implications of Bonus Shares vs. Stock Splits

One of the key differences between bonus shares and stock splits lies in the taxation. When bonus shares are issued, the bonus shares are considered to be received at zero cost for the investor. This means when you sell the original shares, you may incur a capital loss, while the sale of the bonus shares will be treated as a capital gain. In contrast, with a stock split, there is no such tax impact. The cost of each share is simply adjusted backward, so there’s no direct tax effect from the split itself.

Limitations of Stock Splits and Bonus Issues

There are some limitations to both stock splits and bonus issues. For stock splits, if the face value of the stock is already ₹1, it cannot be split further. For a bonus issue, if the company doesn’t have enough reserves and surplus, it cannot issue a bonus. But aside from these restrictions, both stock splits and bonus issues don’t change the earnings per share (EPS) or price-to-earnings (P/E) ratio of the stock. The market reaction to these announcements is usually based on the perception that a lower price will make the stock more affordable and increase its liquidity.

The Sentiment Behind Bonus and Split Announcements

Although bonus shares and stock splits don’t actually give anything extra to the investor, they do affect market sentiment. A lower stock price after a split or bonus issue may attract more buyers, increasing the liquidity of the stock. This is often seen as a positive move, even though the fundamentals of the company haven’t changed. For example, Berkshire Hathaway has famously never split its stock, and one share is worth several crores of rupees. Warren Buffett’s strategy is to keep the stock price high so that only serious, long-term investors can buy into it.

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