In the world of stock markets, you might often hear the term “Bonus shares.” It’s a relatively simple concept, but for new investors or those unfamiliar with corporate finance, it can seem a bit confusing. This blog aims to break down and Understanding Bonus Shares: A Comprehensive Guide what bonus shares are, why companies issue them, and how they affect shareholders. Let’s dive in!
What Are Bonus Shares?
Bonus shares are additional shares that a company gives to its existing shareholders at no extra cost. They are a type of corporate action, similar to dividends. However, instead of paying cash, the company rewards its shareholders with more shares. These shares are distributed in a certain ratio, which means that shareholders receive extra shares based on the number of shares they already own. For example, in a 1:1 bonus issue, shareholders receive one additional share for every share they own.
In essence, bonus shares are the company’s way of saying “thank you” to its shareholders without draining its cash reserves.
Why Do Companies Issue Bonus Shares?
There are several reasons why companies opt to issue bonus shares instead of paying cash dividends or other forms of returns:
- Conserving Cash for Business Growth:
One of the main reasons companies issue bonus shares is to conserve cash. Instead of distributing profits as cash dividends, they retain the money in the business for expansion, debt repayment, or working capital needs. It’s a win-win for both the company and shareholders: the company can continue using its cash for growth, while shareholders get more equity. - Sign of Confidence:
Issuing bonus shares is often viewed as a sign that the company is performing well and confident about its future growth prospects. When a company decides to issue bonus shares, it signals to the market and shareholders that its financial position is strong. - Increase Stock Liquidity:
When a company issues bonus shares, the number of shares in the market increases. This often leads to improved liquidity, meaning it’s easier to buy and sell the stock in the market. Liquidity is crucial for attracting investors, especially in smaller companies where trading volumes might otherwise be low. - Attracting New Investors:
Bonus shares can make the stock price more affordable. When more shares are issued, the market price of each share typically decreases. For example, if a stock is trading at 100 and the company announces a 1:1 bonus issue, the price per share will likely adjust to 50 after the bonus. This lower price can attract new retail investors who may have previously found the stock too expensive.
How Do Bonus Shares Work?
Let’s explain this with an example.
Imagine you own 100 shares of Reliance Industries, which is currently trading at 200 per share. The company announces a 2:1 bonus issue, which means for every two shares you own, you will receive one additional share. So, if you own 100 shares, you will receive 50 more shares, bringing your total to 150 shares.
However, after the bonus issue, the price per share will decrease. So, if Reliance Industries stock was trading at 200 before the bonus issue, the price might drop to 133.33 (roughly) after the bonus. This is because the total value of your investment stays the same (100 shares at 200 = 20,000 before the bonus, 150 shares at 133.33 = 20,000 after the bonus). The market adjusts the price to account for the increased number of shares.
What Are the Benefits of Bonus Shares?
Bonus shares offer several benefits, both for the shareholders and the issuing company. Let’s take a closer look at some of these advantages:
- Increased Shareholding:
Bonus shares increase the number of shares an investor holds, which can be beneficial if the company performs well in the future. Although the market price of each share decreases, the overall value of your investment remains the same. As the company grows and its share price increases, you will benefit from holding a greater number of shares. - No Immediate Tax Implications:
In most countries, receiving bonus shares doesn’t lead to immediate tax liability, as there’s no actual cash transaction. Shareholders might only face tax implications when they sell the shares at a later date, depending on the capital gains tax regulations in their country. - Positive Market Sentiment:
Issuing bonus shares can boost the company’s image in the market. Investors and analysts often view it as a sign of the company’s good health. It can also signal that the company’s management is confident about future earnings growth. - Boosts Liquidity:
By increasing the number of outstanding shares, bonus shares often lead to improved liquidity in the stock market. More shares mean easier buying and selling, which can attract more traders and long-term investors. - Affordable Stock Prices:
After a bonus issue, the market price of each share typically drops. While this might sound like a negative, it makes the stock more affordable to smaller retail investors. This can widen the shareholder base and increase trading volume.
What Are the Drawbacks of Bonus Shares?
While bonus shares offer many benefits, there are a few potential drawbacks investors should be aware of:
- Diluted Earnings Per Share (EPS):
Since bonus shares increase the number of shares in the market, they can dilute the company’s earnings per share. However, this doesn’t necessarily mean the company’s profits are shrinking. It simply means the earnings are now spread across a larger number of shares. - No Immediate Financial Gain:
While cash dividends provide immediate income to shareholders, bonus shares do not. Investors who rely on dividend income might prefer cash dividends over bonus shares, especially if they’re looking for regular cash flow from their investments.
How Do Bonus Shares Affect Stock Prices?
After a company issues bonus shares, the stock price usually adjusts downward to reflect the increased number of shares. However, the total value of an investor’s holdings remains the same. For example, if you owned 100 shares of a company priced at 100 per share (total value 10,000), and the company issued a 1:1 you would now own 200 shares, but the price per share would likely drop to 50. The overall value would still be 10,000.
Conclusion: What Should Investors Do?
Bonus shares are a great way for companies to reward shareholders while preserving cash for growth. For investors, they provide additional shares at no cost and can lead to long-term benefits if the company continues to perform well.
However, it’s important to remember that bonus shares don’t immediately increase the value of your investment. They can dilute EPS and result in lower stock prices in the short term. Investors should always look at the company’s overall health, future prospects, and why the bonus shares are being issued before making any investment decisions.
Whether you’re a seasoned investor or just starting, It important concept to understand. Keep an eye on company announcements and market trends to make informed decisions that align with your financial goals.