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.
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