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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Bonus Shares are just a Market Gimmick

Bonus Issue is issue of free shares by the company to its existing shareholders. And since we love 'free' things, we love bonus issues. But beware – they are just a big hype. You gain NOTHING from it.

Financially speaking, bonus shares are issued by converting a part of the free reserves (i.e. the reserves & surplus accumulated by the company over the years, mainly out of the profits retained in the past) into share capital. The reserves are reduced and the share capital is increased equivalent to the same amount.

Suppose a company, having a share capital of Rs.100 crores and reserves of Rs.500 crores, issues bonus share in the ratio of 1:1. Then, its share capital will increase to Rs.200 crores and reserves will reduce to Rs.400 crores. So there is no change in the company’s net worth, which remains the same at Rs.600 crores.

Say you are holding 100 shares in the company. And if the Current Market Price is say Rs.200, your investment value works out to Rs.20,000. After the bonus issue, your shareholding increases to 200. 

But does it mean that your investment value increases to Rs.40,000? 

No, that’s not the case. Since the shareholding has doubled, the EPS will become half. And assuming that the PE ratio remains the same, mathematically the share price also falls to half i.e. Rs.100. Thus, your investment remains the same at Rs.20,000. Hence, there is no change in your investment value. 

Therefore, essentially speaking, the shareholder is not getting anything free. In fact he is not getting anything at all – free or otherwise.

The only gains from bonus issues could be increased tradability & liquidity.

Psychologically, a stock of Rs.100 share appears cheaper than a stock of Rs.200. Therefore, more people are willing to buy such a stock. Secondly, the number of shares has doubled, which increases the stock’s liquidity. Because of this increased demand & liquidity, the stock may not fall exactly to Rs.100, but may trade around Rs.110-120. Thus, because of the sentiment, your investment value may improve a bit to say around Rs.22,000-24,000.

But, there is risk too.

People are used to receiving certain dividend. Now, with doubled shareholding, company will have to shell out double the amount as dividend if it aims to maintain its dividend percentage record. The question arises – does the company generate enough profits to meet this increased dividend outflow? If not, the company will have to reduce its dividend percentage. This could have negative impact on the sentiment. Hence the whole purpose of improving the sentiment may be defeated.

The company and the investor must keep this point in mind, before considering the bonus issue.

By the way, even stock splits do not do anything to add any ‘real value’ to the stock. It is only the improved liquidity (due to more no. of shares) and tradability (due to more affordable prices) that can give some kick to the stock.

Note :  Warren Buffett, legendary investor and the world’s 2nd richest man for many years now, does not believe in these gimmicks. He has, therefore, never gone for bonus or stock splits in his company Berkshire Hathaway; even though a single share of the company is today traded at around US$ 130,000 (and hence out of reach of an ordinary investor). His value investing methods are no secret. But they require lot of discipline and patience, which unfortunately most of us lack.

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