In the realm of equity investing, companies often reward their shareholders not only through dividends but also through bonus shares. This corporate action, while non-monetary in nature, plays a significant role in enhancing shareholder value and shaping long-term portfolio returns. For both seasoned investors and beginners, understanding what bonus shares are and how they influence Earnings Per Share and market perception is crucial.
This article delves into the concept of bonus shares, the rationale behind their issuance, their effects on shareholders’ returns, and how they influence key financial metrics.
What is a bonus share?
A bonus share is an additional share issued by a company to its existing shareholders at no extra cost, based on the number of shares already owned. These shares are distributed from the company’s free reserves or retained earnings. In essence, they represent a capitalisation of profits, meaning the company converts a portion of its reserves into share capital.
For example, if a company announces a 1:1 bonus issue, shareholders will receive one additional share for every share held. Therefore, if an investor owns 100 shares, they will receive 100 more, taking the total holding to 200 shares.
It is important to note that bonus shares do not involve any cash outflow from the company or the investor. Instead, they dilute the shareholding structure while maintaining the proportional ownership of each shareholder.
Why companies issue bonus shares
There are several strategic reasons why companies choose to issue bonus shares:
1. Rewarding shareholders
Bonus shares serve as a gesture of appreciation to existing shareholders. They indicate strong financial health and profitability, reassuring investors about the company’s performance.
2. Improving liquidity
Issuing bonus shares increases the total number of shares in circulation, which can lead to improved trading volumes and liquidity on the stock exchange. This can make it easier for investors to buy and sell the stock.
3. Bringing down the share price
In cases where a company’s share price is relatively high, bonus issues can make the stock more affordable for retail investors by reducing the price per share proportionately. This can encourage wider participation in the stock.
4. Signal of confidence
By issuing bonus shares, a company may signal its confidence in future earnings and stability. It shows that the management believes in consistent profitability and long-term growth.
Impact on shareholders
Bonus shares have both psychological and financial implications for shareholders. Let us examine the various ways in which they impact investor holdings and portfolio value.
a) No change in total investment value
Although the number of shares increases post-bonus, the overall investment value remains the same immediately after the issuance. This is because the share price adjusts in proportion to the bonus ratio. For example, if the share price was Rs. 500 before a 1:1 bonus issue, it will drop to approximately Rs. 250 after the issue, while the number of shares doubles.
b) Increased number of shares
The most direct impact is an increase in the number of shares held by each investor. This can create a perception of increased wealth, even though the total value remains unchanged in the short term.
c) No immediate tax liability
Since bonus shares are issued free of cost, there is no tax applicable at the time of receipt. However, when these shares are sold, capital gains tax will apply based on the holding period and the cost of acquisition, which is considered as zero.
d) Long-term wealth creation
While there is no direct monetary benefit, bonus shares can lead to long-term wealth creation if the company continues to grow. The increased number of shares can result in larger dividends and capital appreciation over time.
Effect on Earnings Per Share (EPS)
One of the most notable impacts of bonus shares is on Earnings Per Share. EPS is calculated as:
EPS = Net Profit / Number of Outstanding Shares
When bonus shares are issued, the number of outstanding shares increases. Assuming net profit remains unchanged, this leads to a lower Earnings Per Share. This dilution is purely mathematical and does not indicate any deterioration in profitability. However, it is essential for investors to interpret EPS correctly post-bonus issuance.
A decrease in EPS after a bonus issue does not necessarily mean reduced efficiency. Instead, it is a result of the increased denominator in the EPS formula. Analysts and investors often adjust their EPS expectations in line with the bonus ratio to maintain accuracy in performance comparisons.
Impact on share capital and reserves
Bonus shares result in an increase in the company’s paid-up share capital. However, there is no change in the net worth, as the increase in capital is matched by a corresponding decrease in reserves.
For example, if a company has Rs. 100 crore in reserves and decides to issue bonus shares worth Rs. 20 crore, its reserves will reduce to Rs. 80 crore while the share capital will rise by Rs. 20 crore. The balance sheet remains balanced, but the structure of shareholders’ equity changes.
How investors should respond
For investors, bonus shares can be a welcome development, but it is important to take a measured view:
- Evaluate the company’s fundamentals and long-term growth prospects. A bonus issue from a fundamentally strong company is a positive sign.
- Do not assume that bonus shares translate into instant profits. While the number of shares increases, the price adjusts, and the overall value remains stable initially.
- Use bonus issues as a signal of management confidence and consider them as part of your long-term investment planning.
- Keep track of the ex-bonus date and record date to ensure eligibility for bonus shares.
Real-world example
Suppose an investor owns 500 shares of a company trading at Rs. 600 per share. The company announces a 2:1 bonus issue. This means for every share held, the investor will receive two additional shares.
- Original holding: 500 shares × Rs. 600 = Rs. 3,00,000
- Post-bonus holding: 1,500 shares (500 original + 1,000 bonus)
- Adjusted price: Rs. 600 ÷ 3 = Rs. 200 (approximate)
- Total value: 1,500 shares × Rs. 200 = Rs. 3,00,000
The investment value remains the same immediately, but the number of shares has tripled, offering potential for higher gains in the future.
Conclusion
Bonus shares are a strategic tool used by companies to reward shareholders without distributing cash. While they do not directly increase the market value of investments in the short term, they improve liquidity, build investor trust, and support long-term value creation. Understanding the effect of bonus issues on metrics such as Earnings Per Share, share capital, and market dynamics allows investors to interpret corporate actions more accurately.
By staying informed and analysing bonus share announcements within the context of a company’s fundamentals, investors can make better financial decisions and strengthen their long-term investment portfolio.
