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What is meaning of Bonus shares and why Company declares them. Advantages and Disadvantages of Bonus shares
What is meaning of Bonus shares
Definition of Bonus shares: Bonus shares are additional shares given to the current shareholders free of cost. Company declares Bonus shares in ratios like 4:1 (4 for 1 bonus) ,1:2 (1 for 2 ) ,1:1 (1 for 1).
If you have 100 shares of a particular company and if company issues 3:2 bonus (three-for-two bonus) you will get three shares for every two shares. So if you have with 100 shares then you will receive 150 bonus shares (100 x 3 / 2 = 150) which are totally free of cost. So your shares will rise from 100 to 250.
Terms to know to understand related to bonus shares
1. Ex Bonus:
It means after the record date. It is the date on which the share price is adjusted on stock exchanges according to the bonus ratio
2. Record Date:
The cut-off date fixed by a company to determine who is eligible to get bonus shares. You get the benefit only if you have shares in your demat account on this date
How the stock price changes after a bonus issue?
Usually, after the bonus issue, the share price of the company gets adjusted according to the bonus ratio. For example, if the price before bonus is Rs 200 and a company issues bonus shares in the ratio of 1:1, the post-bonus share price will be Rs 100, which means that the total market value (2 x Rs 100=Rs 200) remains the same.
Let's see a few examples:
1) The record date for Matrix Labs' 4 for 1 bonus was January 13, 2005. At the time, the stock price was around Rs 2,116. Ex-bonus, the stock adjusted to Rs 423.
Note: Rs 423 is Rs 2,116 divided by 5, which is entirely appropriate because there are now 5 stocks where there used to be 1.
2) Company called Aftek Infosys, which gave a 1 for 2 bonus on January 27, 2005. The stock was Rs 109, falling to Rs 73 ex-bonus. Rs 73 is exactly two-thirds of Rs 109. But while the stock price of Aftek Infosys rose substantially prior to the bonus, Matrix Labs had not.
3) Glenmark Pharma's 1:1 bonus on March 4 saw the stock correcting from Rs 593 to Rs 296.
How the stock price changes
A bonus issue adds to the total number of shares in the stock market.
Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, totally there will be 30 million shares.
Now the earnings of the company will have to be divided by that many more shares.
Earnings Per Share (EPS) = Net Profit/ Number of Shares
Since the profits remain the same but the number of shares has increased, the EPS will decline.
Why Company gives Bonus shares?
The following few reasons why company declares bonus shares
1) Companies issue bonus shares to encourage retail participation and increase their equity base.
2) In addition, increasing the number of outstanding shares decreases the stock price, making the stock more affordable for retail investors. When price per share of a company is high, it becomes difficult for new investors or retail investors. Increase in the number of shares reduces the price per share.
3) Companies low on cash may issue bonus shares rather than cash dividends as a method of providing income to shareholders. Because issuing bonus shares increases the issued share capital of the company, the company is perceived as being bigger than it really is, making it more attractive to investors.
4) However, issuing bonus shares takes more money from the cash reserve than issuing dividends does. Also, because issuing bonus shares does not generate cash for the company, it could result in a decline in the dividends per share in the future, which shareholders may not view favorably.
5) When a company issues bonus shares, the shares are paid for out of the cash reserves, and the reserves deplete.
6) Another reason could be, bonus shares are issued by cashing in on the free reserves of the company. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.
Advantages of bonus shares
1) The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.
2). A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future.
3) A bonus issue is taken as a sign of the good health of the company.
Should You Buy?
If you want to buy shares of companies which are going to announce bonus issues, hold on. One should not buy purely on the basis of expected bonus shares unless one is certain about the fundamentals of the company.
A bonus issue is a sign the company is expanding equity and increasing liquidity, but it is not the only indicator of performance. Investors should take a decision after analysing the fundamentals of the company.
Bonus shares lead to adjustment in the share price according to the proportion of dilution. So, the price comes down in the immediate term. However, in the long run, the share price depends on the fundamentals and growth prospects of the company.
It is recommended to study the company and its prospects before taking a call on investing.
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updated on 30 Aug 2017