Young Investor

May We Help You? - No rewards in bonus issues

BL RESEARCH BUREAU | Updated on September 24, 2011

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Ever been delighted by your company issuing bonus shares? Well, maybe its time for a rethink. Claims about bonus being a ‘reward' to shareholders don't hold much water. Here's why.

Zero-sum game

If you moved your money from your right pocket to the left, would you become any richer? Similarly, bonus issues do not really result in wealth-addition for shareholders. This is what happens in bonus issues – the company simply transfers funds belonging to the equity shareholders, from one accounting head (reserves and surplus) in the balance-sheet to another (share capital). The latter will increase to the extent that the former decreases.

The net worth of the company (share capital + reserves) essentially remains unchanged. For the shareholder, it is a zero-sum game, since the increase in number of shares is offset by the decrease in earnings per share (net profit/number of shares). Post-bonus, the market price of a stock also adjusts to reflect the increase in shares arising from the bonus issue.

Why bonus issues?

So if bonus issues don't appear to serve any purpose for shareholders, why do companies still resort to it? One of the major reasons is that a higher number of shares improves float and liquidity and thereby traded volumes of the stock. A lower price also makes the stock seem more affordable to small retail investors, who might otherwise give it a miss at high price levels.

Theoretically, the share price, post-bonus, should adjust in exact (reciprocal) proportion to the increased capital base. For example, a 1:1 bonus, which doubles equity capital, should ideally reduce the share price by half.

However, this need not always be the case, given that market price is influenced by several factors, important among which is also the increased equity capital base due to the bonus issue. Greater investor interest in the scrip improves price discovery and accentuates price movements. This, combined with the general positive sentiment associated with bonus shares, at times, results in the share price being traded higher than the theoretical post-bonus price.

Companies which plan to raise equity capital also sometime resort to bonus issues to make the offer seem affordable to retail investors. In some cases, a bonus share can be a ploy to mask flagging performance and perk up sentiment. The effects, though, will be transient.

A good aspect is that it may reflect the company's confidence in its ability to service a larger equity base. Thus, bonus issues are said to be a good signalling mechanism on the company's capacity to deliver future benefits to shareholders in terms of increased dividend if dividend payouts are maintained or increased. However, such benefits which flow from the fundamental strength of the companies are contingent upon future performance, and do not constitute immediate rewards for the shareholders.

Caution while comparing

While doing a multi-period comparison of a company's performance, it is important to adjust the reported results (e.g. EPS) of previous periods for increase in number of shares due to the bonus issue. This is essential to enable meaningful comparison, else erroneous inferences are possible. So, the next time you hear about how bonus issues “reward” shareholders, take it with a pinch of salt!

(Need any other investment-related help? Write in to us at >younginvestor@thehindu.co.in)

Published on September 17, 2011

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