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.

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