Why are bonus shares issued and what are their advantages?

by Manshu on May 24, 2013

in Investments

Rajeev posted the following comment yesterday:

Rajeev Srivastava May 22, 2013 at 6:06 pm [edit]

Hi Manshu,

I am curious to know about implications of bonus issue of shares. Is there any existing post on this at onemint?

Rajeev

This is a good topic for a post, and I thought I would broaden the scope a little and answer why a company issues bonus shares and then my opinion on the implications of a bonus issue. I use ‘opinion’ because I’m not going to use any data to share what I think about bonus issues.

Why does a company issue bonus shares?

When a company issues a bonus shares the price of its existing shares come down by about the same ratio as the bonus shares that have been issued. So if the bonus issue is 1:1 which means they are issuing one additional share for each existing share, the market price of the share will roughly halve.

When the price falls, the liquidity of the share improves, and that to me is the primary reason for a company to issue bonus shares. I think an example shows this quite well. What if a single share of a company was Rs. 93,26,940 – how many people do you think will trade in this share?

What if the same share was worth Rs. 6,177? Wouldn’t a lot more people now trade in this share?

The two prices I took were the price of Berkshire Hathaway’s class A and class B shares. Warren Buffett’s Berkshire Hathaway never paid a dividend, issued a bonus, or conducted a split for decades and as a result their class A share is worth roughly $167,000.

I feel that the primary reason for all splits and bonus issues is allowing the share price to fall in value to facilitate trading.

What are the advantages of issuing bonus shares?

Facilitating trading is the one big benefit of issuing bonus shares, but this is from the perspective of the company, how do investors benefit from bonus issues?

People view bonus issues as a positive action, but I’m not sure why that is. As soon as the number of shares increase, the value of each share goes down in value, so theoretically there are no gains to be had just because of a bonus issue.

I came across a Business Today article about the features and advantages of bonus issues and according to the data they analyzed – there is a good chance that the companies that issued bonus shares rise in the year after the issue. You can read the whole article to see the data they looked at and then their interpretation of it. My own opinion on this is that this is one of those things where correlation does not always mean causation.

The companies they looked at rose, but what about other similar companies? How much did the companies that rose actually rose and for how long? They stopped after a year but what after that year?

I don’t know what the answer to these questions is but I’ve never come across anything that showed without doubt that bonus issues  are an indication that the company will outperform the market.

{ 8 comments… read them below or add one }

santonu May 24, 2013 at 8:19 am

Could you explain which is more benificial to the investors split or bonus. I assume bonus is benificial as face value of the stock is not changed.

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Mkd May 24, 2013 at 1:19 pm

While the analysis will be spot on for share split, won’t for bonus the equity base increase?
That is some reserves would be capitalized to create the new shares to be distributed to shareholders. Also wouldn’t the ratios having equity in denominator also change.

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Manshu May 24, 2013 at 9:41 pm

Yes, you are correct. The equity base rises and the capital increases. The reserves will go down as some of the reserves will be capitalized to issue shares, and then the EPS will decline as the number of shares will increase. There are several other effects on ratios as well and it depends on whether equity or number of shares are used.

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Prashant May 24, 2013 at 3:04 pm

Had a question , do the promoters also get bonus shares when the bonus share are declared. If yes then they are the ones who benifit the most as they have got the shares at face value.

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Manshu May 24, 2013 at 9:35 pm

Yes they also get the shares, but they don’t benefit more than others since everyone gets shares for free and then everyone gets the same market price as others.

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Rajeev Srivastava May 25, 2013 at 2:15 am

Thanks Manshu, Your post is really very informative.

Reply

Karthik Reddy Chintaparthi May 27, 2013 at 12:24 pm

I have a general query here. Let us say a company offers 1 bonus share for every 2 shares, if I hold 5 of them then how much will I recieve ? Is it only 2 bonus shares ? If yes what about the fifth share I have ? Does it not have any value ? Usually how does companies these sort of situations. Please explain.
Thanks, Karthik

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santonu May 28, 2013 at 12:09 pm

Value of 5th share will be credited to your bank account

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