Folly of Bonus Shares
Media pundits and business experts are again beating the drums of bonus shares from Reliance. And we all individuals, without giving the thought, start beating the drum of the bonhomie, and are rejoicing that we are getting something for free. Because it is termed as “Bonus”, it is free and we all should be happy for it. Happy that company management is thinking about shareholders and giving them “Bonus Shares”. Coming from school of “value thinking” I believe this is fools paradise. We have lost our ability to think rationally and then make a judgment call. Let us discuss little bit more….
For example, let us say there is a company ABC Ltd. At a given point in time, the company has 100 shareholders. Each shareholder invested Rs 1.00 in the business. Hence the capital base is of Rs 100.
ABC Ltd has a good business model and over a period of time it makes good profit. The per share book value of the business (note: not stock market price) increases to, say, Rs. 57. Therefore, the book value of the business is now at Rs 5,700 [57*100].
At the same time, ABC Ltd has also accumulated total profits of Rs 8000.
At this point in time, let us say stock market price is Rs 67. We will not be using this but just note that “book value” is different “stock market price”.
Therefore, the original shareholders have following real ownership or value preposition:
- 100 shareholders own Rs 13,700 (book value + of accumulated profits).
- This ownership of Rs 13,700 is across 100 shares.
The management decides they want to make use of Rs. 8000 in profits. It is not good to keep profits lying around and doing nothing. I agree that profits needs to invested back into business or returned to shareholders.
The management of ABC Ltd decides to return shareholder value as a bonus shares. Instead of returning shareholder the actual cash, management uses “accounting process” to return the value.
- It decides to issue bonus shares and increase capital base.
- Each shareholder receives bonus shares. So now the shareholder has increased to 200 shares (instead of only 100 shares). i.e. 100 shareholders have 200 shares.
- The ownership base of ABC Ltd is now increased to Rs 11,400 [book value, 5700 + (57*100)]
- Company continues to keep remaining Rs. 2300 [8000-5700] in profits.
- Finally, we have 100 shareholders, have 200 shares, and value preposition is still Rs 13,700 (11,400 + 2300)
Here is the really folly of bonus share…
Where is the bonus in this accounting process? 100 shareholders still own the same value (book value + profits on books). There is nothing free in here. The management has transformed the profits into number of shares.
In layman terms, management uses accumulated profits to pay for your so called bonus shares. There is nothing free here? What is there to rejoice?
I have only discussed immediate implication. I have not discussed its long term affect.
Food for thought…
- Consider what majority shareholder(s) can do? Can he/she sell bonus shares at stock market price and still keep majority ownership? If yes, can this be interpreted as majority shareholder(s) indirectly taking profits? What do you think?
- Why not pay dividends to all shareholders? That is another simple way of distributing profits to shareholder? Do you know why converting profits-to-shares are more advantageous?
Let me know your thoughts by leaving your comments below.
bonus shares, capital base, capitalization, dividends, profits, reliance, reliance dividend, RIL Bonus issue, RIL dividend, value
Hi,
One of the impact of bonus shares is that it shows the % divident paid is less than otherwise. Now whether it is an advantage to company or not is depends on the situation.
Other thing may be that it improves the general sentiment about the stock.
Cheers,
Sachin
Sachin,
I agree with both points. On the sentiment: that’s the brokerage house driven sentiments, otherwise how will they have increased trading volume?
I am writing the post on re-balancing and profit booking. I wanted to let you know I have not forgotten about it.
Best Wishes,
TIP Guy,
Thanks your response.
and thanks for keeping track of my question, waiting for your post.
You seems to read my mind
Cheers,
Sachin
Advantage of bonus – as the market price get reduced one can show the sale proceeds as loss and adjust it with some other profit.(both short term)
Hello Hemal,
My understanding is the cost basis is also revised downwards, so loss cannot be claimed. If that were the case, everybody will rush to sell, collapsing the company’s share price.
Best Wishes,
I disagree with ur interpretation of cost calculation of original shares and bonus shares. Original shares are treated at original cost and date of acquisition, while bonus shares are treated as free and date of allotment. So u can sell the original shares booking loss, and hold the bonus shares for more than 1 year, thereby earning LTCG which is exempt. This also the reason for the heightened activity in any scrip immediately before and after its ex-bonus date. Further if u calculate the overall price movement, ignoring other things in the immediate 7-10 days after ex-date, generally the adjusted share price is lowers than the cum-bonus price…
I see the following reasons…
1. share price comes down…. and more transactions… may be will keep actively traded one… (preferred choice of traders)
2. Share Capital is increased
3. Dont have to pay dividend dist tax
4. Retail investors thinks itz free(Company admired)
5. in the case of reliance, they might have had the global acquisition in mind.. so dont have to actually pay the cash out.. keep the profits for acquisition.
(1) and (4) are perceived advantages. It really does not have any merit.
(2) Share capital increase is not necessarily good. It can be bad too. For same earnings, it you distribute to higher capital base, it will reduce EPS and ROCE.
(3) this is only what makes sense
(5) i would prefer company using reserves to pay for the acquisition, rather than use increase the capital base. This way they do not dilute the existing shareholders.
the article above was about the meaning of bonus. If you really understand the meaning of bonus, then this is not a bonus. The so called bonus shares were paid from shareholder’s profits. SO they are not bonus. Your share cost basis went down by half.
Thanks for your message.
[Consider what majority shareholder(s) can do? Can he/she sell bonus shares at stock market price and still keep majority ownership? If yes, can this be interpreted as majority shareholder(s) indirectly taking profits? What do you think?]
I don’t think this is possible. With the same example of ABC, if suppose only one holder had 50 shares out of 100 and after the bonus, he would have 100 out of 200. This is 50% holding. If he decides to sell his bonus share at the market price which would now be Rs 33.5 (your example had the CMP 67), he is essentially selling 50% of his ownership and thus reducing his stake. I mean to say, if a majority stakeholder also decides to sell the bonus share, it affects his overall stake in the company.
And if he only sells 10% after bonus? Indirectly cashing in on reserves which where in balance sheet, but not in his/her account? A general observation is after the bonus split, the shares tend to trade above proportional value difference. Mean in case of 1:1 bonus, shares usually trade above 50% value.