What Are Bonus Shares? A Comprehensive Guide For Investors
Investing in the stock market offers a multitude of investment avenues, one of which is through receiving bonus shares. For those new to the concept, understanding what bonus shares are can be an enriching experience and provide insights into how companies reward their long-term investors. This comprehensive guide elucidates the concept of bonus shares, their advantages, and their effect on company valuation and investor wealth.
What Is a Bonus Share?
What is a bonus share? is essentially a free share awarded by a company to its existing shareholders. These shares are distributed in a specific ratio, such as 1:1, meaning for every share held, an additional one is given. The issuance of bonus shares is one of the methods companies use to share their profits with existing shareholders, following the principles of rewarding long-term growth and stability in shareholding.
How Are Bonus Shares Different from Dividends?
A bonus share differs from a dividend in its form of payment. Dividends are cash payouts to shareholders, drawn from the company’s profits. For instance, if a company’s share price is INR 100 and it declares a 5% dividend, shareholders receive INR 5 for each share they hold. Bonus shares, on the other hand, involve no cash outlay by the company. Instead, shareholders receive additional shares, thereby boosting their investment in the company without any immediate increase in the company’s market capitalization.
Why Do Companies Issue Bonus Shares?
There are several reasons companies might choose to issue bonus shares:
1. Reward Shareholders: Issuing bonus shares is a way companies can reward loyal shareholders, offering them more shares without having to invest additional money.
2. Increase Liquidity: By increasing the number of shares in the market, bonus shares can improve the stock’s liquidity and trading activity.
3. Psychological Impact: Investors often perceive bonus shares as a sign that the company is performing well, thus improving the investor sentiment and potentially driving up the share price.
4. Correction of Price: Bonus shares help in lowering the per-share price, making it more affordable for potential investors. For instance, a share priced at INR 1000 might be split to make the shares trade at a more accessible price for retail investors.
Example of Bonus Share Calculation
To better understand the mechanics of bonus shares, consider the following example:
Company XYZ announces a 1:2 bonus share issue. Shareholder A holds 200 shares at a market price of INR 300 each. With the 1:2 bonus ratio, A will receive one additional share for every two shares held (200 shares / 2 = 100 bonus shares). Thus, upon issuance, A will hold 300 shares (200 original + 100 bonus).
Changes in Stock Price
The issue of bonus shares does not mean an increase in the company’s overall market value. Post bonus issuance, the share price often adjusts downward to reflect the increased number of shares in circulation.
In our example, before the bonus issue, the market capitalization of XYZ was:
\[ 200 \text{ shares} \times \text{INR} 300 \text{ per share} = \text{INR} 60,000 \]
Post bonus issuance, the total number of shares becomes 300. Assuming the market capitalization remains unchanged, the new share price would be:
\[ \frac{\text{INR} 60,000}{300 \text{ shares}} = \text{INR} 200 \text{ per share} \]
Effect on Shareholder Wealth
Although the share price drops, the overall value for shareholders remains consistent. Shareholder A’s wealth remains at:
\[ 300 \text{ shares} \times \text{INR} 200 \text{ per share} = \text{INR} 60,000 \]
Thus, bonus shares reward shareholders by increasing the number of shares they hold, without a direct capital appreciation or cash dividend.
Advantages of Bonus Shares
Issuing and receiving bonus shares offer multiple benefits:
1. No Immediate Tax Liability: Unlike dividends, which are taxable, receiving bonus shares does not generate immediate tax liabilities for shareholders, thus making them a tax-efficient form of reward.
2. Sign of Financial Health: Companies issuing bonus shares can signal strong financial health, as bonus shares are typically given from retained earnings.
3. Increased Allotment: Shareholders receive more shares, potentially leading to higher future capital gains if the stock appreciates.
Potential Downsides
While bonus shares can be advantageous, they come with possible downsides:
1. Dilution of Value: Since the issuing of bonus shares increases the number of shares in circulation, it may dilute the earnings per share (EPS) as the profits are spread over a larger number of shares.
2. No Cash Benefit: Bonus shares do not provide any immediate cash benefits to investors unlike dividends.
3. Market Perception: If not well-received, the issuance of bonus shares might cause adverse market movements, affecting the share price.
Conclusion
Bonus shares are an important part of corporate finance and play a pivotal role in rewarding long-term shareholders. By converting their retained earnings into free shares for shareholders, companies can increase the stock’s liquidity, signal robust financial health, and maintain investor relations.
Understanding the mechanics of bonus shares, their implications on share prices, and the inherent advantages and pitfalls is crucial for investors. While they do not directly impact investor wealth immediately, the impact on liquidity, market perception, and long-term gains can be significant.
Disclaimer
Investing in stocks, including those listed on the Indian stock market, involves risks. Investors must conduct thorough research and consider all possible risks before making any investment decisions. The information provided in this guide is for educational purposes and should not be construed as financial advice. Always consult with financial advisors to tailor investments to your individual needs and risk appetite.
