Bonus, splits, rights issue and buybacks explained

Bonus, Splits, Rights issue and Buyback explained

June 20, 2018 2 Ankit Shrivastav

Bonus, Splits, Rights issue and Buyback explained

If you ever watch business channels, you will find them using lot of financial terms unknown to common man. As a beginner, I was always confused with these term, and had to go through multiple pages to understand the meaning of each of these terms.

Fortunately, you don’t have to go through all that trouble, as in this post I would explain, in detail, some of the most commonly used technical terms used.

Out of all the financial jargons, the ones that confuse investors the most are the bonus, split, rights issue and buybacks.

The purpose of this post is to clear all your doubts regarding these terms. After reading this post carefully, you will be able to understand the meaning of each term and will also be able to understand how it impacts your investments.

Bonus shares

Bonus Shares:

Simply put, a bonus share is a free additional share, which a company provides in addition to the shares you are already holding. Bonus shares are form of dividends paid in the form of additional shares instead of cash.

The purpose of issuing bonus shares is to reward shareholders of a company. The bonus shares are declared and issued in terms of ratios.

For example, if a company issues bonus shares in the ratio of 1:2 it means that for every 2 shares held by you, you get one share for free.

How bonus shares are issued

How Bonus shares are issued?

Bonus share is simply a dividend, which is paid in the form of additional stocks instead of cash. Bonus shares are issued form the reserves and surplus account of the balance sheet of the company, which gets transferred to share capital account.

So is bonus issue simply a settlement of accounts? Yes, but this small adjustment can make a huge impact on the company.

Reserves and surplus account is retained earning of the company over the years, which a company can use for funding its future business expansions.

When bonus shares are issued, the amount needed to fund gets transferred from reserves and surplus to Share capital account and cannot be used by the company for future.

How does Bonus Shares Impact Shareholders

How does Bonus issue impact shareholders?

Bonus share is simply a dividend, which is paid in the form of additional stocks instead of cash. Bonus shares are issued form the reserves and surplus account of the balance sheet of the company, which gets transferred to share capital account.

So is bonus issue simply a settlement of accounts? Yes, but this small adjustment can make a huge impact on the company.

Reserves and surplus account is retained earning of the company over the years, which a company can use for funding its future business expansions.

When bonus shares are issued, the amount needed to fund gets transferred from reserves and surplus to Share capital account and cannot be used by the company for future.

What is a stock split?

Stock Split:

Before we understand that a stock split is, it is important to familiarize yourself with a term called face value.

Face Value: Face Value of a share is a nominal value of a share. Back in the old days, when shares were issued in physical form, face value was the nominal value shown on each share certificate.

Face value is also known as accounting value and is used in accounting for balance sheets purposes of a company’s stock.

Stock split, in simple words is breaking or splitting up of one share into multiple share. Stock split is usually done when the market value of each shares becomes expensive and it has very few participants.

Impact of stock splits

Impact of stock split and Why it is done?

Stock split does not change the share capital of the company nor does it requires additional shares to be issued. It is simply breaking up of one stock into many. Stock split simply changes the number of shares held by you and the face value of each share.

To understand it in a simple way, imagine you have a Rs. 10 note. If someone gives you ten one rupee coins in exchange of one single note of Rs. 10, you will still retain the value, but it will now be easier to spend this money as you can now break it into multiple parts.

Stock split is similar to this. Stock split is usually done when the market price of each share becomes expensive and it has very few participants.

Splitting stocks brings down the price of each share, making it easier for investors to trade and thus provide liquidity.

Unlike bonus shares, stock split does not change the share capital of the company, However, the face value of the stock changes proportionately.

For example, if a company splits its stock in a ratio of 1:5, it means that each share with a face value of Rs. 10 will split into five shares and the face value of the stock will change from Rs. 10 to Rs. 2 (10/5=2).

To an average person, both stock split and bonus look same as in both the case the market price of the stock changes proportionately. So how is issuing bonus different from stock split? Let’s take a quick look.

difference between bonus and stock split

Difference Bonus vs Stock Split:

  • Bonus is additional shares, split is splitting of one share into many
  • Bonus Shares does not change the face value split changes the face value  
  • Issuing Bonus requires transfer of capital from reserves to share capital account split does not require any such changes
  • Bonus shares are Issued with intention to reward shareholders while split is done to increase liquidity.
rights issue

Rights Issue:

Rights issue provides existing investors or shareholders of a company to buy additional shares of the company. In other words, But you can always buy shares from the exchange? Then how is rights issue any different?

The shares issued during rights issues are given at a discount to the prevailing price. For example, if a company’s stock is trading at a market price of Rs. 100, companies issuing rights shares may issue rights shares below prevailing market price. This is done to make rights issue attractive to shareholders.

A rights issue provides a shareholder a right, and not an obligation if he wants to buy additional shares of a company.

The rights issue remains open for a shareholder for a minimum of 15 days to maximum 30 days.

A shareholder may decide not to buy or even sell his rights in the exchange to other investor just like an ordinary share. Rights issue, unlike bonus shares causes equity dilution.      

Let us now understand the difference between bonus and rights issue.

Difference between rights and bonus

Difference between rights and bonus:

Bonus is issued to every shareholder, in case of rights issue, company has to ask the shareholders for their consent before issuing shares.

Bonus shares are issued for free, for rights issue, shareholders have to pay extra for buying Bonus shares are issued at the prevailing market price, while rights shares are issued at a discount to the prevailing market price.

Issuing bonus shares does not raise further capital for the company, while rights shares are issued to raise capital to be used by the business.

Issuing bonus shares does not cause equity dilution, while rights issue causes equity dilution of each shareholder.

what is a buyback

Buybacks:

Peter Lynch once said “There can be many reasons why the owner of a company may sell his holding, but there is only one reason why he would buy back his shares, and that is because the stock is undervalued”

Buyback is opposite of rights issue, where company buys back its shares from shareholders at a premium to the market price. Buyback is also called shares repurchase.

Buybacks allow companies to invest in themselves increasing their shareholder value. Buybacks are usually done when a company feels that the market price of its shares is undervalued compared to its intrinsic value. However, buybacks can be done for multiple reasons such as to prevent a takeover, to buy out departing shareholder.

How do buybacks take place?

When a company declares a buyback, it announces two dates, one from date, that is the date from which company will start buying shares from the market, and to date which is the last date of buying shares of a company.

The company also declares a price which the company is willing to buy these shares and the number of shares that it is willing to buy. The price at which companies buy back their shares is at a premium to the market price, making buybacks attractive for investor.

There are two ways buybacks can take place. First from the open market and second by tender offer.

Open Market offer: This is the most common method of share buyback and takes place in almost 90% of the time in buybacks. The open market offer usually remain open for months to even a year, during which, the company can decide to buy shares from the open market.

However, there are some restrictions to the number of shares that can be bought during a day.    

Tender Offer: A tender offer often occurs when an company proposes buying shares from every shareholder of a publicly traded company for a certain price at a certain time. As mentioned earlier, the offer price of such buybacks is higher than the prevailing market price, making buybacks attractive.

The difference between tender offer and a open market buyback is that unlike open market offer, tender offer are valid for a specified date.

It is important to understand that not every buyback is beneficial for shareholders as some of the companies use it as a way of utilizing their surplus capital in a tax efficient manner, instead of giving dividend as it attracts 20% dividend distribution tax to the company.
Buybacks that involve promoters of a company as buyers are usually considered more reliable and beneficial for shareholders in the long term.

impact of buybacks

Impact of Buybacks:

Buybacks are usually seen as a big positive by shareholders as its a strong sign that the company has faith in its business.Apart from the psychological boost to the shareholders, buybacks also have impact on various aspects of a company.

Change in number of outstanding shares: The first impact a buyback has on a company is the change in number of outstanding shares.

Outstanding shares refer to a company’s stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders. When a company buys back its shares, the number of outstanding shares reduce

EPS(Earning Per Share): Since buybacks reduce the number of outstanding shares, the biggest impact can be seen on the EPS of the company. EPS is calculated by dividing net profit of the company with total number of outstanding shares.

Since buybacks reduce the number of shares while net profit remains the same, the EPS suddenly gets a boost. Let me explain it with the help of a simple example.

Example: Let us assume a company has 100 outstanding shares and net profit of Rs. 10,000. If we divide the Net profit with number of shares we get an EPS of Rs. 100 per share (10,000/100=100).

Now if the company decides to buy back 20 of its outstanding shares, the total number of outstanding shares reduce to 80.

With net profit remaining the same, EPS will now change from Rs. 100 per share to Rs. 125 per share (10,000/80=125).

A share buyback also has significant impact on the balance sheets as a share buyback reduce the total cash holding of the company. The buyback also shrinks shareholders equity and the performance metrics such as ROA(Return on Asset)  and ROE(Return on Equity) subsequently improve.

Final words

Conclusion:

All the terms explained above are different from each other, and have a different purpose to fulfill. Bonus are like stock dividend instead of cash dividend and are beneficial for companies that want to reward shareholders without shelling out cash from their pocket.

Bonus declarations usually boos the price of a stock for a short term as every investor wants to have free shares.

Splits are very useful for the companies whose shares are expensive and thus there is low trading volume. Splitting shares does not affect the company’s financials in any way but helps increasing trading volumes by reducing the price of the share.

Rights issues is used by the company to raise further capital from the existing shareholders. Since rights issues raise capital for the company it is important for an investor to investigate where the money raised is going to be used, the past financial performance of the company, and how honest and reliable the managements is.

Finally the buybacks, are usually seen as a positive as its a sign that the market price of the share is undervalued compared to the intrinsic value of the company and the company has faith in its business.    

I think these were the most important terms related to shares that most investors find really confusing.

I hope these were helpful and I was able to clear your confusion.

Do let me know in the comments if there are any other terms you want me to write about in detail.

Total Comments ( 2 )

  1. pravin patil says:

    This information very useful for new investor