Bonus shares !!

What are bonus shares?
Bonus shares are those allotted by the company to existing shareholders, free of cost. The company does this by capitalising its free reserves. Assume a company with an equity capital of Rs 500 crore and free reserves of Rs 1,000 crore. If this company issues a 1:1 bonus (one free share for every held), its equity capital will double to Rs 1,000 crore. The extra Rs 500 crore is shifted from the free reserves to the equity capital, and the shareholders given the bonus shares. The company’s equity capital is now Rs 1,000 crore and its free reserves Rs 500 crore (Rs 1,000 crore minus Rs 500 crore).

Why do companies issue bonus shares?
Bonus shares are usually issued to improve liquidity in a stock, and give a feeling to the investor that the stock price has become more affordable. This helps in improving the sentiment for the stock, especially among retail investors, as he can now own more number of shares for the amount of one share earlier. Following the bonus issue, the stock price will correct to the extent of the bonus ratio. For instance, if the ratio is 1:1, the stock price will halve, if the ratio is 2:1 (two bonus shares for every one share held), the stock price will become one-third.

Will Reliance shareholders benefit from the 1:1 bonus issue announced a couple of days ago?
That depends on whether the company will maintain the per share dividend payout at Rs 13 next year also. If the company pays a dividend of Rs 13 per share next year, it would mean doubling of dividend for shareholders, since they will now be owning twice the number of shares.

What could have been the reason for Reliance Industries to announce a bonus issue at this stage?
Market view is divided. Some say the move is a genuine gesture to reward the loyal base of retail shareholders. Others point out that the company is trying to boost sentiment for the stock at a time when it is mired in a legal battle with ADAG over gas supply, and grappling with subdued growth in earnings near term.

Should investors be excited about the RIL bonus share issue?
A liberal bonus issue does indicate confidence on the part of the management to be able to service the expanded equity base. Besides, in India, the general trend has been that of stock prices factoring in the bonus issue faster than expected. What this means is that if a stock is quoting at a pre or cum-bonus price of Rs 100, and falls to Rs 50 after the bonus issue, it will climb back to Rs 100 faster than a corresponding rise in earnings. Though irrational, this has been the general trend.

Does a bonus issue make a difference to the fundamentals of the company?
No. It does not change anything for the company. The net worth of the company (equity capital + free reserves) will remain the same, growth in absolute profits and profitability will depend on the company’s efficiency levels and market conditions. Earnings per share (earnings divided by the number of shares in issue) will come down in absolute terms, but the price to earning multiple (stock price divided by earnings per share) will remain the same, as the stock price too would have reduced to the extent of the bonus issue.

Other than the prospect of more dividend, what is the attraction of a bonus issue?
Many investors use bonus shares to offset short-term capital gains tax. For instance, an investor can buy a stock just before the bonus issue, sell the bonus share once the stock price adjusts, and show that transaction as a loss while retaining the original share. This loss can be adjusted against the short-term capital gain the investor has made in some other transaction.

Is a bonus share issue the same as a stock split?
No. In a stock split, the face value of the share is reduced. If the company reduces the Rs 10 rupee face value of a share to Rs 5, an investor with one share of Rs 10 face value will have two shares of Rs 5 face value. In case of a stock split, the equity capital remains unchanged, but the number of shares in absolute terms, increases.