About Splits and Bonuses and slices of pizzas!

We all understand how bonus and splits do not affect the financials of a company and the experts have argued that it is merely a book entry. A bonus issue of 1:1 was similar to cutting a pizza into half and so on and so forth. Some time back we discussed the various issues that came up with a bonus and a split and we also discussed that except for a stamp of confidence as to how the management sees itself over the next few quarters these transactions do not affect a company’s performance and hence should be price neutral.

The effects of a bonus and a split on a company’s fundamentals are:

1)      It reduces the share price but also reduces the EPS but the PE remains same.

2)      Number of shares increases but their price falls but the wealth remains unchanged and so does the market cap.

3)      3)) RoE and RoCE remains same post the bonus and split.

4)      There is no change in any of the profitability, turnover liquidity and solvency ratios.

Then what is it that makes the stocks which declare a bonus or a split goes up?

1)      After the bonus or the split the stock appears “cheap”. Even if it is a mirage it is a fact that retail investors love low priced stocks.

2)       All retail investors want to hold shares in round numbers. So while they would not buy 5 shares of ITC at Rs 2000 they would surely buy 100 shares of ITC at Rs 100 (after the bonus and split).

3)     After a bonus and a split the liquidity in a stock improves and that encourages the institutional investors to take meaningful positions in the stock. In the June carnage I used to see trades on 500 shares of Pantaloon bringing down the price by Rs 150 .In other words a trade of Rs 65,000 was removing  Rs 400 crores of market cap!

4)      Thus while the stock price does rise after the split the rise is directly proportional to the increase in the number of shares. For example a company subdividing its Rs 10 share into 2 shares of Rs 5 each may see lesser increase compared to another company that increases the subdivides the Rs 10 share into 10 shares of Rs 1 each.

5)     In the table below I have included a very small sample of companies and the trends showed that over a period of 6 months the increase in stock price varied from 10% to 60% depending on point (4) above.

Thus while a bonus and a split does not affect the fundamentals of company it does change the demand and supply dynamics (technical) and that results in an increase in price. Now we could call that temporary but what ever it is the stock does get rerated for a higher PE as liquidity improves. Generally liquid stocks trade at higher PE's.

·         Nagarjuna recently came out with another bonus issue at 1:1

·         Unitech and Infosys still have time before they complete 6 months of bonus/split.

·         We have been calculating the effects of a bonus and a split in the midst of a secular bull market and in fundamentally strong companies. Would be interesting to see the effect on companies that are losing on fundamentals.

Finally this was just an exercise to look for reasons and no investor should buy a stock just because it was being split or a bonus is being issued because such an event does not affect the fundamentals. In case the fundamentals deteriorate the stock could fall after a bonus/split irrespective of what the ratio is.

Thanks. My sense is that a bonus/split acts just as a catalyst to creating market cap. Generally I do not think that any company should get in for  split or a bonus unless its stock price exceeds Rs 500. In any case it is a misnomer because with dematerialization investors can buy even one share of a company.