Bonus and Splits – Slices of the Same Pizza

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I received a postal ballot to approve bonus shares for a company I hold.  Generally March quarter is the quarter when bonuses and splits are announced by companies to improve investor sentiment.  It is believed by most of the investing public that Bonus and Splits are like free checks that have been given to them by companies which enhance shareholder value.  In fact most of the companies report this (in their annual report) as if these are shareholder value enhancing.  Is this just a myth or is the value creation real?  To answer this, let us go through some basics.

Let us say you start a lemonade stand in a great location with dream to make lot of money out of that business.  Let us say you are the only shareholder in your business.  You have invested Rs.1000 to start the business and you have borrowed say Rs.500 from bank.  For the 1000 rupees you invested, you issue yourself 100 shares with a face value of Rs10.

In the first year, assume you made a huge profit of Rs 800 (net profit after taxes and interest payments) on your business as your lemonade was a great success.  You want to improve your business by opening more lemonade stands, so you retain all the profit that your business made.  So, at the beginning of second year your balance sheet would look like this 

Liabilities – (Amount your owe to someone)

             Equity     - 1000   (Amount you invested which the company owes to you)

             Reserves – 800 (Profit that your business retains for expansion which belongs to you)

             Debt       –  500 (Amount the company owes to the bank)

Total Liability      - 2300  (Sum of all liabilities)

Assets -   (Things that your company owns)

            Fixed Asset –   500 (Lemonade Stand, Jugs, Cooler etc.)

            Inventory     -  1000 (Lemons, sugar, Salt etc.)

            Cash in Bank - 800

Total Assets            - 2300   (Sum of all Liabilities)

Let us answer a few questions now based on the balance sheet

Who does the Rs.800 belong to?

In addition to the Rs.1000 that you invested during start, the additional profit of Rs 800 belongs to you the shareholder.  The lemonade stand could have given this entire amount to you as dividend if it does not want to expand.  It just retains it for future expansion (shown in reserves in liability section) and you can stake claim on it anytime you want it.  So, your total networth in the company is 1000 + 800 = Rs.1800.

The book value of your lemonade stand is 1800/100 shares = 18.  So, the value of each share of your lemonade went from Rs 10 which was your initial investment to Rs.18 at the beginning of second year.

What is bonus share?

We found that our book value is now, Rs18.  You just want to increase the number of shares you have (bonus) so you issue a bonus of 8 shares for each 10 shares that you hold.  With this decision the Liabilities section of the balance sheet would look like this

Liabilities

              Equity – 1800 (Total 180 shares now including bonus shares)

          Reserves –      0 (Money moved from Reserves to Equity)

                Debt –   500

 Total Liability -  2300

So, the total liability remains the same, it is just that the same 1800 is now divided by 180 shares instead of 100.  Now the Book value of each share would come down to  1800/180 shares = Rs.10 instead of Rs 18.

In summary, with bonus shares you gain nothing.  The total claim of yours is Rs.1800 and it remains the same.

What is a Split?

Split is the most useless activity of all.  It is nothing but splitting the face value of your shares.  Remember that you had 100 Shares with a face value of Rs10.  Let us say you wanted to increase the number of shares you hold.  You just bring down the face value of your share to Rs 1 instead of 10 and now you will have 1000 shares instead of 100 shares.  Please note that your equity is the same Rs1000 before and after split.  It is just the face value and the number of shares that is changing.  If you did not have a split the book value of your share would have been 1800/100 shares = 18.  Now that you have 1000 shares with face value of 1 the new book value would be 1800/1000 = Rs1.8

This is almost like you changing one 10 rupee note and getting 10 one rupee notes.  The total value remains the same, only the number of notes has increased.  Split is exactly that.

Bonus and Splits reminds me of a joke.  A blonde went to buy a Pizza and after ordering, the assistant asked the blonde if she would like her pizza cut into six pieces or twelve. “Six please” she said, “I could never eat twelve!  .   

Always remember, it’s always the whole pizza (Rs.1800 in our example) that is being split into pieces. From the above explanation hopefully it is clear that Bonus and Splits are a useless activity which does not enhance any shareholder value. Companies do this only to attract speculators and to boost their share price temporarily. While this may work for very short term it does not work in the long term. If you are a long term investor, this should have no difference for you. Warren Buffet has never split his stock or given bonus shares. The class A shares of Berkshire trades at USD 168450 per share and remains the highest traded stock in US.