Issuing bonus shares is different from a stock split. Let us first understand what happens in each of these cases.
In a bonus issue, the company gives free shares to its existing shareholders on a pro-rata basis. For instance, if a company declares a bonus of 2:1, the investor gets two additional shares for each share that he already owns. Thus a company does not raise additional capital through a bonus issue. It merely converts some of the free reserves (profits accumulated over the years that have not been distributed as dividend) into share capital and issues additional shares to investors. The net impact is that the company's reserves decline while its share capital increases. And that's exactly the purpose behind issuing bonus shares - converting some of the excess reserves into share capital.
A stock split results in the conversion of a high-priced stock into a low-priced stock. For instance, if the stock currently has a face value of Rs10, its face value could be reduced to Rs 2 and five shares could be issued to the investor in lieu of every Rs 10 share held by him. In this case, the face value of shares is reduced in a certain proportion and the number of shares is increased in the same proportion. Again, the total share capital of the company remains unchanged. After both these measures - a stock split and a bonus issue - the net worth of the company remains unaffected.
Let us now go on to your next question regarding why companies go in for a bonus issue or a stock split, and how they decide which of these two options to go for.
Generally, companies that are fundamentally strong and feel that their stock has become highly priced go for a stock split. The basic idea is to make the shares more affordable for retail investors, who otherwise might give its shares a miss at high price levels. Usually stock splits increase the liquidity of the stock in the market. After the split, the stock becomes more affordable and hence more investors are able to buy it. Due to increased demand, the stock's price moves northward, which is the basic underlying motive for the stock split.
The biggest benefit of issuing bonus shares is that it sends out a positive signal that the company is in a position to service its larger equity base. Management does not increase the number of shares unless it is confident of being able to increase its profits and distribute dividends on all these shares in future. Hence, an issue of bonus shares is treated as a sign of the company's good health by the market.
Impact on investors
Investors see a bonus issue as a mark of management's confidence in the company's prospects. Most investors view a bonus issue as a reward to them. Similarly, a stock split too is welcomed by investors. However, in reality both a stock split and a bonus issue are a zero-sum game for shareholders. Let's see what this means.
After a bonus issue, though the number of shares held by an investor increases, his proportional ownership of the company's shares does not change. As the number of outstanding shares of the company increases, its earnings per share (EPS) declines. Theoretically then the share price should also fall by the same factor as the decline in EPS. Hence the increase in number of shares is offset by the decline in stock price. In a nutshell, a bonus issue doesn't impact investors' wealth. However, more often than not, the consequent demand push for shares causes the price to move up. So investors do get some benefits after all.
Stock splits too bring no real advantages to investors. However, post the split of a fundamentally strong company, more investors get attracted to the stock which is less expensive now. This increases the demand for the stock, thereby leading to an increase in its price, which may then stabilise at a higher level.
