Bonus shares are additional shares issued by a company to its existing shareholders, usually in proportion to their current holdings. For example, if a company issues bonus shares in the ratio of 1:1, shareholders receive one additional share for every share they already own.
Bonus shares do not require shareholders to make any additional payments. Instead, they are distributed out of the company’s accumulated profits or reserves. Essentially, bonus shares are a way for companies to convert retained earnings into paid-up capital. While the shareholders gain additional shares, the total value of their investment remains unchanged—unless there is an increase in the market price of the stock after the bonus issue.
How Do Bonus Shares Work?
Bonus shares are typically issued by companies that have accumulated significant reserves but may not want to distribute cash dividends due to liquidity constraints or a desire to reinvest profits into the business. When a company decides to issue bonus shares, it makes an announcement outlining the ratio of bonus shares to be issued. For example, a company might announce a 1:2 bonus issue, meaning for every two shares an investor holds, they will receive one additional share.
Here’s how the process works:
- Announcement: The company announces the bonus issue, specifying the ratio (e.g., 1:1, 2:3, etc.) and the record date, which is the cutoff date for determining eligibility.
- Record Date: Shareholders who own shares as of the record date are eligible to receive the bonus shares. Those who buy shares after the record date will not be entitled to the bonus issue.
- Issue Date: The company issues the bonus shares on the specified issue date. The additional shares are credited to the accounts of eligible shareholders.
- Effect on Stock Price: After the bonus shares are issued, the total number of shares outstanding increases. This often leads to a dilution of earnings per share (EPS) because the company’s profits are now spread over a larger number of shares. However, the market price of the stock usually adjusts to reflect the bonus issue, which compensates for the increase in the number of shares.
Purposes of Issuing Bonus Shares
Companies issue bonus shares for various reasons, and these reasons can vary depending on the specific needs of the company and the economic conditions at the time. Some of the key purposes include:
1. Rewarding Shareholders
Bonus shares are one way for companies to reward their existing shareholders, especially when cash dividends are not feasible or when a company prefers to retain its cash. Shareholders benefit from receiving additional shares, which can lead to increased value in the future if the company’s performance improves and the stock price rises.
2. Improving Liquidity and Marketability
Issuing bonus shares can increase the number of shares in circulation, making it easier for investors to buy and sell shares. This increased liquidity can make the stock more attractive to potential investors, especially institutional investors who may be concerned about the marketability of a stock with low trading volume.
3. Adjusting Share Price
Bonus shares are often issued to adjust the share price to a more attractive level for smaller investors. If the price of a company’s stock has risen significantly, bonus shares can lower the price per share, making the stock more affordable and appealing to a broader range of investors.
4. Capitalizing Reserves
By issuing bonus shares, companies convert their reserves or accumulated profits into paid-up capital. This helps maintain a balanced capital structure and ensures that reserves are effectively utilized. The company may prefer to issue bonus shares rather than distributing cash dividends, especially if it needs to reinvest its earnings into growth initiatives.
5. Strengthening Investor Confidence
A well-timed bonus issue can strengthen investor confidence by signaling that the company is financially healthy and has sufficient reserves to reward its shareholders. It can also indicate that the company is growing and is in a strong position to distribute profits in the future.
How Bonus Shares Impact a Company
Bonus shares have several effects on the company, both in terms of its financial standing and its relationship with shareholders. These impacts can be positive or negative depending on the circumstances of the issue.
1. Dilution of Earnings Per Share (EPS)
When a company issues bonus shares, the total number of shares outstanding increases. As a result, the company’s earnings per share (EPS) are diluted because the same profits are now spread across a larger number of shares. While this does not affect the company’s overall profitability, it can have an impact on key financial ratios and investor perception.
For example, if a company earns $10 million in net profit and has 1 million shares outstanding, the EPS would be $10. However, if the company issues an additional 1 million bonus shares, the total shares outstanding will increase to 2 million, and the EPS will fall to $5.
2. Impact on Share Price
While the issuance of bonus shares results in a higher number of shares outstanding, the total market value of the company remains the same. In theory, the market price of the stock adjusts to reflect the bonus issue, and the share price is reduced in proportion to the number of new shares issued. For instance, if the company issues a 1:1 bonus, the share price may halve immediately after the bonus issue.
However, if the company continues to perform well, the stock price may rise over time, offsetting the dilution caused by the bonus shares.
3. No Immediate Cash Outflow
Unlike cash dividends, which result in an outflow of cash from the company, bonus shares do not require any immediate cash payments. This can be particularly beneficial for companies that want to retain cash for reinvestment or to fund expansion plans. The ability to issue bonus shares allows the company to reward shareholders without depleting its cash reserves.
4. Positive Signal to the Market
Issuing bonus shares can be seen as a positive signal by the market. It may indicate that the company is performing well, has healthy reserves, and is confident about its future growth prospects. A bonus issue can also improve the company’s marketability by making its shares more affordable and increasing their liquidity.
However, investors should carefully assess the reasons behind the bonus issue. If a company issues bonus shares in the absence of strong financial performance, it may be an attempt to mask underlying issues.
Advantages of Bonus Shares
Bonus shares offer several advantages to both the company and its shareholders:
1. Retaining Cash in the Business
One of the primary advantages of issuing bonus shares is that it allows a company to reward shareholders without using cash. For companies that need to conserve cash for expansion or other growth initiatives, bonus shares are a great way to maintain a strong capital base while still showing appreciation to shareholders.
2. Increased Liquidity
When a company issues bonus shares, the number of shares in circulation increases, which enhances liquidity. This makes it easier for investors to buy and sell shares, which can improve market depth and stability. For smaller companies or those with low trading volumes, issuing bonus shares can help increase the attractiveness of their stock to institutional investors.
3. Encouraging Long-Term Investment
Bonus shares can encourage long-term investment by making the stock more attractive to smaller investors. By increasing the number of shares and lowering the price per share, companies can attract a larger and more diverse group of investors. This can lead to increased demand for the stock over time.
4. Positive Market Perception
Issuing bonus shares can create a positive perception of the company in the market. It signals to investors that the company is performing well, has healthy profits, and is confident in its ability to grow. This can strengthen shareholder loyalty and attract new investors.
Disadvantages of Bonus Shares
While bonus shares have numerous advantages, they also come with some potential disadvantages:
1. Dilution of Earnings Per Share (EPS)
As mentioned earlier, the issuance of bonus shares results in the dilution of earnings per share. This means that, even though shareholders receive additional shares, the company’s profitability on a per-share basis decreases. This dilution can negatively affect key financial metrics and investor perceptions, especially if the company’s performance does not improve following the bonus issue.
2. Impact on Dividend Payments
Since the number of shares outstanding increases after a bonus issue, the company may have to pay higher dividends if it maintains a consistent dividend payout ratio. This can put additional strain on the company’s finances, especially if it does not have sufficient profits to cover the increased dividend payments.
3. Potential Negative Market Reaction
If a company issues bonus shares without clear justification or in the absence of strong financial performance, it may create confusion or concern among investors. A poorly timed or unnecessary bonus issue can be interpreted as an attempt to artificially inflate the stock price or conceal underlying financial difficulties.
4. No Immediate Cash Benefit to Shareholders
Although shareholders receive additional shares, they do not receive any immediate cash benefit from a bonus issue. Shareholders may need to sell some of their bonus shares to realize value, which could lead to a decline in the stock price post-issue if too many shares are sold in the market.
Bonus shares are a valuable tool in corporate finance, offering companies a way to reward shareholders without depleting their cash reserves. They can improve liquidity, enhance marketability, and signal financial strength to investors. However, bonus shares also come with the potential downside of diluting earnings per share and affecting investor perceptions. As such, companies must carefully consider their financial health, market conditions, and shareholder expectations before issuing bonus shares.
For investors, bonus shares provide an opportunity to increase their holdings in a company, but they should also be mindful of the impact on EPS and the broader market implications. Understanding the role of bonus shares in corporate strategy can help both companies and investors make informed decisions in the ever-evolving world of finance.
