Back to basics: Bonus shares

What are bonus shares and how do they help investors? Adhil Shetty explains the fundamentals

Ever glanced through the business section of a newspaper and wondered what it means for a company to announce bonus shares?

Though an infrequent phenomenon in the life cycle of a company, they can add significantly to an investor's wealth or trading corpus.

Familiarise yourself with bonus shares and everything you need to know about them as a beginner, intermediary, or advanced investor.

What is a bonus share issue?

Just like a bonus is a welcome additional payment from your employer, bonus shares are free shares issued to you as a shareholder in a company.

The bonus shares are issued in accordance with the number of shares you hold.

Bonus shares are therefore announced in the form of a ratio like 1:1 or 2:1 etc. A 1:1 bonus share offer will mean you will get one share for every share you hold.

Likewise a 2:1 offer means you get 2 shares for every share you hold. Interestingly, this is issued to you at no additional cost.

For example, let us assume you own 100 shares in a Company A and 100 shares of a Company B. Let us assume both companies announce bonus shares. While Company A announces a 1:1 offer, Company B offers them 2:1.

With Company A, you get 100 additional shares taking your total shares to 200, while for Company B you get 200 additional shares taking your total to 300.

Why companies issue bonus shares

As a shareholder in a company, there are various ways in which a company may reward you for being an investor in their company. A common way is by giving out dividends which are absolutely tax free in the hands of the investor. Another way is by issuing bonus shares.

Bonus shares also give the impression that the company is doing fundamentally well and is in a financially healthy state.

One may wonder why companies issue bonus shares and what they gain out of it if they are free. Sometimes, a company’s stock may face liquidity issues. A company’s stock may sometimes become too expensive for people to buy and sell leading to limited trading. With an issue of bonus shares, the overall share price comes down due to a higher supply of shares in the stock market, which augurs well for higher trade volume of the company’s shares.

Who pays for these bonus shares?

Certainly, bonus shares are free for you as an investor, but someone has to pick the tab. A company can accumulate a part of its profit as ‘free reserves’. Over a period of time, the company builds on its free reserve.

Now, when a company has to issue bonus share, it converts this free reserve stockpile into capital. This way the company’s profits remain untouched as and when they issue bonus shares.

How are bonus shares issued?

When a company plans to issue bonus shares, it first announces its intent of doing so along with a record date for the issue. From the time of announcement till the record date (the day on which the bonus gets facilitated) the shares are called ‘cum bonus’.

On the record date, the overall share prices of the company are adjusted to account for higher number of shares but keeping the overall market capitalisation the same as earlier. Once the bonus is given out, share prices are adjusted accordingly and the shares are called 'ex-bonus'.

Investors' options when bonus shares are issued

Bonus shares are distributed only after an approval from the company’s board of directors. As an investor in the company you cannot choose to reject the bonus shares on offer. Also, since there is no deduction or cost at your end, there is no real reason for you to say no.

Many investors often look at buying shares of a company that has announced bonus shares. While bonus shares do imply the company is doing well, that alone should never be your reason for investing in a company. Check the fundamentals of any company, and only if they appear to be strong in the long term should you invest in any company.

Essential aspectsyou should know about bonus shares as an investor:

Bonus shares give you extra shares as per your shareholding at no extra cost.

Issuing bonus shares helps companies increase liquidity and bring down the share price, leading to better trade volume.

Bonus shares do not guarantee improved financial health of the company.

Issue of bonus shares leads to share price adjustment of the company.

Since EPS is calculated as a ratio of net profit and number of shares, with bonus shares the EPS (earnings per share) of a company comes down.

Photograph: caliparisien/Wikimedia Commons

The author is CEO, BankBazaar.com