Equity Research puzzles, solved step by step

Puzzles
100
Traced to a firm
19
Topics
11
Hard
30
Topic
All topicsProbability and brainteasers12Expected value and decisions8Market sizing and estimation12Returns and compounding9Valuation riddles12Three statement riddles10EPS and share count9Cost of capital and rates8Growth, mix and unit economics8Mental maths6Data and reasoning traps6
Level
AnyWarm upCoreHard
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Showing 1–2 of 2 · filtered from 100Clear filters
  1. 043A company whose shares trade at Rs 800 announces a 1:1 bonus issue. What happens to the share price, EPS and the P/E?EPS and share countWarm upIndian brokerage researchSell-side equity research

    Try it first

    What happens to the P/E after the bonus?

    Show the worked solution

    The price falls to about Rs 400, EPS halves, and the P/E is unchanged. A 1:1 bonus gives one free share for each share held, so the share count doubles while the business, its profit and its value do not change. With EPS of, say, Rs 40, EPS becomes Rs 20 and the price Rs 400, leaving the P/E at 20x and the market value at Rs 8,000 crore.

    If shareholders get free shares, why are they not richer?

    Cut a pizza into eight slices instead of four and nobody gets more pizza. A bonus issue changes how many slices the company is cut into, not the size of the company, so each slice is worth proportionally less. A holder of 10 shares at Rs 800 had Rs 8,000; after the bonus she has 20 shares at Rs 400, still Rs 8,000. Nothing was paid and nothing was received.

    A 1:1 bonus cuts the same pie into twice as many slices of half the size800400Before: 10 crore shares at Rs 800After: 20 crore shares at Rs 400samepieBefore to afterPrice800 to 400EPS40 to 20P/E20x to 20xMarket value8,000 crNet worthunchanged
    The company is still worth Rs 8,000 crore after a 1:1 bonus, cut into 20 crore shares at Rs 400 instead of 10 crore at Rs 800, so EPS halves and the P/E stays at 20x: a bonus changes the slice count, not the pie.

    What happens in the accounts?

    The company moves an amount equal to the face value of the new shares out of reserves and into share capital. Net worth is unchanged, because money only moves between two lines inside equity. No cash moves, profit is untouched, and the dividend per share usually halves unless the board chooses to keep it, which would then be a real increase in payout.

    BeforeAfter 1:1 bonus
    Shares, crore1020
    Price, Rs800400
    EPS, Rs4020
    P/E20x20x
    Market value, Rs crore8,0008,000
    Every per-share number halves and every whole-company number stays the same.

    The analyst's housekeeping: restate past EPS, dividends per share and price charts for the bonus, otherwise the history shows a false halving. Say the limitation too. In practice the price can drift from the exact half, because a lower share price can widen the pool of buyers, but that is a market effect, not a change in value.

    Where candidates lose it

    The common slip is calling the stock cheaper after the bonus because the price halved. The P/E is the test, and it has not moved.

    The second loss is forgetting to adjust history. A model that compares this year's EPS of Rs 20 with last year's unadjusted Rs 40 shows a collapse that never happened.

    What the interviewer asks next

    • How is a bonus issue different from a stock split in the accounts?
    • Why might a board announce a bonus issue at all?
    • If the company keeps the dividend per share the same after the bonus, what has changed?
  2. 100A company starts its April to March financial year with 100 crore shares and issues 20 crore new shares on 1 October. Net income for the year is Rs 330 crore. What is EPS?EPS and share countWarm upIndian brokerage researchResearch KPO and GCC

    Try it first

    Which share count goes under the Rs 330 crore?

    Show the worked solution

    Rs 3.00, on 110 crore weighted average shares. The 100 crore opening shares count for the full year. The 20 crore new shares existed only from 1 October, half the year, so they count as 10 crore. Rs 330 crore over 110 crore is Rs 3.00. Dividing by the year-end 120 crore would understate EPS at Rs 2.75.

    Why weight the shares by time?

    A flat shared by two people for six months and three people for the next six has housed two and a half people on average over the year, and splitting the annual electricity bill by three would overcharge the one who arrived late. EPS divides a full year's profit by the shares that were outstanding while it was earned, so shares issued mid-year count only for the part of the year they existed. The money raised on 1 October only helped earn profit in the second half.

    The new shares count only for the half year they existed100 crore for 6 months100 crore still there+20 crore new, 6 months110weighted120100Issue on 1 OctoberAprMayJunJulAugSepOctNovDecJanFebMarEPS = 330 / 110 = Rs 3.00. Using year-end 120 gives Rs 2.75; using 100 gives Rs 3.30.
    The company had 100 crore shares from April to September and 120 crore from October to March, a time-weighted average of 110 crore, so Rs 330 crore of net income gives EPS of Rs 3.00.
    The relationship
    Nˉ=100+20×612=110EPS=330110=3.00\bar N = 100 + 20 \times \frac{6}{12} = 110 \qquad EPS = \frac{330}{110} = 3.00
    N barthe weighted average number of shares, crore
    6/12the share of the year the new shares were outstanding
    330net income for the year, Rs crore
    What it says in wordsCount each share for the fraction of the year it existed, then divide the year's profit by that average.

    When is the time weighting not used?

    When no new money comes in. A bonus issue or a share split changes the number of shares without changing the company's resources, so it is applied to the whole year and to comparative years as if it had always happened. If the 20 crore shares had been a bonus issue, the count would be 120 crore for the full year and EPS Rs 2.75, with last year's EPS restated on the same basis. Confirm the exact treatment against the current accounting standard on earnings per share, Ind AS 33 in India.

    Why does an analyst care about the difference?

    Because next year's EPS starts from 120 crore shares for the full twelve months. If profit stays at Rs 330 crore, EPS falls to Rs 2.75 next year even though nothing got worse, simply because the new shares count for a full year. An analyst forecasting growth in EPS has to model the share count forward, not just the profit, or the forecast will look better than the business.

    Where candidates lose it

    The common slips are dividing by the closing 120 crore, which gives Rs 2.75, or by the opening 100 crore, which gives Rs 3.30. Both ignore when the shares were issued.

    The follow-up catches the rest: candidates who time-weight a bonus issue as if it were a fresh issue for cash have missed the one case where the rule changes.

    What the interviewer asks next

    • The 20 crore shares were a bonus issue instead. What is EPS?
    • If the issue had been on 1 January, what would the weighted count be?
    • What will EPS be next year if net income stays at Rs 330 crore?