Reliance or Nykaa bonus shares, TCS or L&T buybacks: Do such corporate actions create value and why Warren Buffett dislikes stock splits

Here is a simple thought experiment to consider. There are two companies A and B. Both are in the same business with identical margins and identical growth prospects. Both have recent FY net profit of ₹1,000 crore. The only difference between the two is this: A has 100 shares outstanding with a face value of ₹10 per share, trading at ₹100 a piece for a market cap of ₹10,000. B has 100 shares outstanding with a face value of ₹ 1 per share, trading at ₹100 a piece for a market cap of ₹10,000. Is there any reason for which you will pick A over B?

Logically there isn’t a case. Both identical companies with identical prospects making equal profits should ideally get the same valuation from a fundamental investing perspective. However, in today’s world, financial engineering has come to fore to create illusions of value creation via corporate actions like bonus shares, stock splits, buybacks over dividends, etc. Here is a lowdown on what matters and does not.

Face value

The face value of a share has no semblance to the worth of the share. Its primary purpose is to serve as an accounting and legal reference point. When a company announces 100 per cent dividend, the immediate question that arises is, 100 per cent of what? The face value serves as reference point in such case as dividends are announced as percentage of face value. So, in the above example, if both A and B announce the same dividend of, say, ₹10 a share, then A’s dividend will be 100 per cent, while B’s dividend will be 1,000 percent, but the key thing to note here is that it makes no difference to the quantum of dividend you receive in your hands.

In a more simplistic way, think of a dish of Italian origin, consisting of a flat round base of dough baked with tomato and cheese and other toppings. Sounds familiar? Well, you could call it a pizza as we all know it, or you could call it a chapati – neither makes a difference to what it is and how it tastes and your experience of it. Same way, a face value in no way impacts the worth of your share. A stock with face value of ₹1 trading in 2 digits in the stock market is not more attractive or valuable than a stock with face value of ₹1 trading in 4 digits in the stock market. The worth of your share is determined by its intrinsic value or the net present value of all its future cash flows/profits attributable to the share.

It would be interesting to note that some of the stocks that have given the best returns globally, such as Apple, Nvidia or Tesla, have minuscule face values. Apple’s face value is $0.00001, Nvidia’s and Tesla’s face value is at $0.001.

Stock splits and bonuses

In a bull market, particularly during euphoric phases, any corporate action tends to be perceived as good news and especially if it is a stock split or bonus. Both are corporate actions that create zero value to a business, but grab news headlines. Market excitement around the same results in upswings in the stock.

What exactly is a stock split? There is a pizza cut into six equal slices of which one slice belongs to you. A stock split is nothing but the same pizza cut into 12 slices and you owning two slices now. Neither has the size (value) of the pizza increased, nor has your share in it increased.

When queried on why he has never split class A shares of Berkshire Hathaway which trades at $540,000, Warren Buffett - the Oracle of Omaha, responded that there is no point in having a lower priced share with more volatility if it isn’t creating intrinsic value for investors.

Stock splits do increase liquidity in the short run as they bring in investors who otherwise may not be able to buy a high-priced stock. But in long term investing, these short liquidity phases even out. Take the  example of two of the largest tyre companies in India: MRF, whose share traded in 5 digits five years back and Apollo Tyres. which traded in 3 digits at the same time. Both have given around similar returns since. Being lower priced, ‘a piece’ does not create more value.

The same logic can be applied to issue of bonus shares as well. Bonus issue is, in substance, many ways similar to a stock split although it varies in form. The difference in form is that in stock split the face value gets split, while in bonus the face value remains the same and extra shares are issued. The difference is largely only on the accounting side. Though there is a tendency amongst market participants to think that bonus is better than stock split as face value remains the same and you can get higher dividends as number of shares is more, this logic is flawed in the Indian context

For example, Reliance Industries gave a 1:1 bonus issue in September 2017. The year before this bonus it paid a dividend of 110 per cent equating to ₹11 a share. The year after the bonus issue, investors had twice  the shares earlier, but the dividend rate reduced to 60 per cent, effectively resulting in no material change in total dividend received. Even in cases where dividend percentage is maintained, given low dividend yields, the impact has not been material.

And if it is genuinely about dividends, companies need not give bonus shares to indicate higher future dividends, they can just do it easier by increasing the dividend percentage.

Nowadays bonus issues have become even more of gimmick with companies such as Nykaa and Easy Trip Planners distributing no or only marginal dividends, but declaring bonus issues.

So, next time you catch headlines around stock splits or bonuses, study the management intentions more.

Buybacks and dividends

Both buybacks and dividends are shareholders’ money distributed to shareholders. The only difference being that in the case of dividends, the money is distributed to all shareholders while in the case of buybacks only a select few (those who want to exit) take the money. However, buybacks typically tend to grab more headlines and buzz than dividends. Is there merit to it? Buybacks increase ownership stake of shareholders who remain, but does it necessarily increase value for them?  

For example, a month back, L&T announced a ₹10,000-crore buyback at a maximum price of up to ₹3,000 per share, which would extinguish 2.4 per cent of its outstanding shares. If the same money was instead paid as dividend to shareholders, it would have translated into a dividend yield (₹10,000 crore/market cap) of 2.6 per cent, with no extinguishment of shares. Does the buyback create more value than the dividend? Not unless L&T is trading below its intrinsic value, in which case the company is buying back shares from investors who are exiting at a discount to intrinsic value and remaining shareholders benefit when market price scales up to intrinsic value over a period of time.

Again, using a pizza as reference, a dividend can be seen as all owners of  the pizza taking an equal bite, while a value creating buyback can be viewed as a few owners willing to exit by taking a smaller bite than their share. In India, unfortunately, with many buybacks in recent years done at expensive valuations, buybacks have been like exiting owners taking a larger bite, leaving remaining investors with lesser intrinsic value. For example the last TCS buyback (Q4 FY22)  priced at a significant premium to intrinsic value saw exiting investors pocketing the gains. To the contrary the last HCLTech buyback (Q3 FY19) done at cheap valuations has created value for shareholders.

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