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Don't be fooled by Bonus Shares

I am sure there isn't a person in this world who wouldn't love to get something for free. As such bonus shares — shares that are given by a company to its existing shareholders totally free of cost — evoke intense joy and euphoria.

Naturally, investors are always on the look out for 'bonus candidates' i.e. companies that are likely to declare bonus in the near future.

Unfortunately, however, bonus shares are a myth like many other myths floating around in the universe of personal finance. (Some more tricks to fool you at 'To Protect Your Money, Don't Read Financial Ads'.)

As you all know, companies that make profits utilize the same in two ways:
i.  Distribute a part of it, to its shareholders, as dividends every year
ii. Retain the balance profits in the company for future growth and expansion.

We all, of course, understand the dividends very well. Anyway, they have nothing to do with the issue of bonus shares. So let us keep them out of the picture here.

Let us focus on the profits retained by the company. These are added to and accounted for in the Reserves and Surplus of the company.  

And, it is from these Reserves and Surplus that the bonus shares are issued. If a company accumulates huge reserves over the years and is unable to deploy it fruitfully into the business, it can decide to return a part of it to the shareholders in the form of additional or bonus shares.

Accordingly, when the company gives out bonus shares it has to equally reduce the Reserves and Surplus. Effectively speaking, the sum total of Share Capital + Reserves  before and after the bonus shares are issued  remains exactly the same.

[By the way, it is these huge reserves that investors look for when scouting around for the likely bonus candidates.]

I guess a small example will clarify this further.

A company has a share capital of Rs.100 crores. Over the years it has built reserves of Rs.500 crores. It decides to issue bonus share in the ratio of 1:1. So post the bonus issue, its share capital will increase to Rs.200 crores and reserves will reduce to Rs.400 crores. In other words, there is no change in the net worth, which remains the same at Rs.600 crores.

Suppose you own 100 shares of the company. Its price, before the bonus issue, was say Rs.200. Thus, your investment in the company worked out to Rs.20,000. 

Now, you get additional 100 shares, free of cost. So, is your investment now worth Rs.40.000? 

No, it isn't!

After the bonus issue, the no. of shares has doubled. Since the business is the same
its valuation i.e. PE ratio remains the same, and
the EPS now becomes half

So the share price drops to half i.e. Rs.100 and your investment remains at Rs.20,000. In other words, there is no change in the value of your investment. 

Hence, don't be fooled by the myth of bonus shares. You don't get anything free. In fact, you don't get anything extra out of it.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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