Monday, 30 November 2015

Why bonus issues make investors happy?

If you've attended an annual general meeting of any company, one question that shareholders never fail to sally forth is, "Chairman saab, is saal bonus issue hai kya?" This sometimes also takes the sarcastic tone of "Bahut deri se aap ne hum chhote shareholders ko koi bonus nahi diya?"

The big "bonus" question seems so important to most shareholders that we thought we should evaluate why they make this supernormal demand. But before we get into the relevance of a bonus issue, we'll touch upon what a bonus issue is and why companies have been issuing bonus issues since time immemorial.
What's a bonus issue?
Bonus is an issue of free shares by a company to its shareholders in proportion to their existing holdings. In short, it means that the company has turned part of the profits and reserves to capital. So while the reserves stand reduced, the capital has increased.
For example: You own 100 shares in a company and the current price is Rs1,000 per share. If the company announces a “one for one” bonus issue and issues you 100 more shares, you now own 200 shares. Does that mean your holding doubles in value? No, because the market will adjust the price of the shares so that the total value of your holding remains what it was before. In the above example, the share price would adjust to about Rs500 per share, so you still have a holding worth Rs100,000. Similarly, the dividend per share will adjust pro rata.
Suppose company A, with an equity of Rs60 crore and reserves of Rs120 crore, announces a 1:1 bonus, there is no change in the net worth but the earnings per share changes. But hold on, the change has been to the extent of the change in the share price. So effectively, there is no change in the share value of the shareholder.
Company (A)
Pre bonus
Ex bonus
New worth
Book value
Price per share
For shareholders
No of shares
Value of holding
= 100,000
= 100,000
What good a bonus issue does?
Wait; there may be something positive about a bonus issue. Let's dwell into this argument further and provide reasons for the relevance of a bonus issue. The main objective of having a bonus issue is to make the shares more marketable. With more shares in circulation and a lower share price, a company expects better liquidity and higher investor interest in its shares. Let's take the example of ABC's shares, which see little activity owing to the illiquid nature of the stock (the company's equity is only Rs4.24 crore). But if ABC were to issue a bonus issue the liquidity in the stock would improve. Also the company would then be trying to signal that it is now capable of servicing a large shareholder base.
Picking the finer points
So far so good. But the important question is: Is that company capable of servicing a large customer base? If so, can it maintain its dividend ratio? Remember, in the next year, the company would have to shell out a larger part of its profits to the shareholders, even if it maintains its previous dividend ratio.
If it does maintain its ratio, it is possible that the company might be putting back a relatively smaller part of profit back into the business. This, in turn, might have other implications for the company.
Let's take the case of XYZ. The company issued its fifth bonus issue in 2012. The bonus of 1:1 was issued to reward its shareholders on its 100th year of operation. But the point is the company was well aware that it would not be able to service its customer base and would not be able to continue with the dividend ratio. The net result: the following year, the dividend ratio fell by 60% to 10% and last year the company gave a dividend of just 6%.

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