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Understanding Stock Actions: Buybacks, Bonus Issue, and Stock Split

ICICIdirect 10 Mins 02 Feb 2024

If you are new to investing, you may have heard of terms like buyback, bonus issue, and stock split. At a high level, it may get confusing to understand the difference between these terms. But as investors looking to stay in the market for long, it is essential to understand them. It will help you navigate the complexities of the stock market. Let us look at these terms in detail in this article.

Stock Action 1: Share Buyback

A share buyback is a process through which a company purchases its own outstanding shares from the market. A buyback can happen in two ways:

  • Open Market: In this option, the company that has announced share buyback repurchases the stocks directly from the stock market. The company usually executes the trade over an extended period, and they specify the maximum price they are willing to pay for the buyback. Infosys announced the buyback program in 2022, where it decided to purchase total shares worth Rs 9300 crore with a maximum price of Rs 1850 per share.
  • Tender Offer: In this option, the company makes a public offer to its shareholders to tender their shares for repurchase at a specified price within a certain timeframe. Unlike open market buybacks, where the purchase price may vary, tender offer buybacks typically involve a fixed price at which the company is willing to repurchase shares from shareholders who choose to participate in the offer. In December 2023, TCS announced a buyback of 1.1% of the outstanding equity through a tender offer at Rs 4150 per share. Depending on interest from investors, the acceptance ratio is decided - how many of your total shares will be accepted by the company for the buyback.

Let us now look at different reasons why a company goes for a share buyback:

Boosting Earnings Per Share (EPS): By reducing the number of outstanding shares, a buyback can increase the earnings per share, even if the company's overall profitability remains constant. It can make the company appear more attractive to investors.

Returning Wealth to Shareholders: Companies may choose to return excess cash to shareholders through buybacks. It demonstrates confidence in the company's future prospects and can lead to an increase in shareholder value.

Preventing Hostile Takeovers: By buying back shares, a company can make itself less attractive to potential acquirers (mostly small companies), thereby defending itself against hostile takeover attempts.

It is important to note that buybacks can also have drawbacks. Some have argued that companies sometimes use buybacks to artificially inflate their stock prices or enrich executives with stock-based compensation, rather than investing in long-term growth initiatives. 

Stock Action 2: Bonus Issue

In a bonus issue, the company distributes additional shares to existing shareholders based on the number of shares they already hold. The action does not change the company's value or the proportionate ownership of shareholders but can increase the liquidity of the stock. Let us understand the process with an example. 

Suppose ABC Limited announces a bonus issue in the ratio of 1:1. It means that for every share held by existing shareholders, they will receive one additional share as a bonus.

Before the Bonus Issue:

  • ABC Limited has 1,000,000 outstanding shares.
  • The market price of each share is Rs 100.
  • Market capitalization = Number of shares * Market price per share = 1,000,000 * Rs 100 = Rs 100,000,000

After the Bonus Issue:

  • Since the bonus issue is in the ratio of 1:1, ABC Limited will issue an additional 1,000,000 shares as bonus shares.
  • Total outstanding shares after the bonus issue = 1,000,000 (existing shares) + 1,000,000 (bonus shares) = 2,000,000 shares.

After the bonus issue, the market price per share may adjust to reflect the increased number of outstanding shares. Assuming the market price per share adjusts proportionally, the new market price per share could be around Rs 50.

Revised Market Capitalization:

  • Market capitalization after the bonus issue = Number of shares * Revised market price per share
  • = 2,000,000 * Rs 50 = Rs 100,000,000.
  • Despite the increase in the number of shares, the market capitalization remains the same as before the bonus issue.

Below are some reasons a company may issue bonus shares:

Capitalizing Profits or Reserves: Bonus issues are often used to capitalize a company's profits or reserves. Instead of paying dividends in cash, the company rewards shareholders with additional shares.

Increasing Liquidity: By increasing the number of outstanding shares, a bonus issue can enhance the liquidity of the company's stock, making it more attractive to investors.

Adjusting Share Price: In some cases, a company may issue bonus shares to adjust its share price to a more marketable range, thereby making the stock more accessible to retail investors.

Stock Action 3: Stock Split

A stock split involves dividing the existing shares of a company into multiple shares, effectively increasing the number of outstanding shares while lowering the price per share. The most common type of stock split is a 2-for-1 split, where each existing share is divided into two shares. For example, if an investor holds 100 shares priced at Rs 100 each before a 2-for-1 split, they would own 200 shares priced at Rs 50 each after the split.

Does it sound similar to a bonus issue? While both stock splits and bonus issues increase the number of outstanding shares, they serve different purposes and have distinct mechanics and impacts on share prices and shareholder value. One major difference lies in the stock's face value. It is the value of stocks listed in its books and share certificate - it remains fixed and usually has Rs 10 as value at the time of issuance unless there is a stock split. In a stock split, as seen above, the same shares are being split in a specific ratio, and the face value also gets divided in the same ratio. In the bonus issue, the face value remains the same.

Here are key reasons for undertaking stock splits include:

Improving Liquidity and Accessibility: By reducing the price per share, a stock split makes shares more affordable to a broader range of investors, thereby enhancing liquidity and marketability.

Psychological Impact: A lower share price resulting from a stock split may attract more retail investors who perceive the stock as more affordable or undervalued, potentially driving up demand and share prices.

Before you go

Buybacks, bonus issues, and stock splits are critical corporate actions that can have significant implications for investors and companies alike. By comprehending the motivations behind these actions and their potential effects on shareholder value and market dynamics, you can make more informed decisions in your investing journey.

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