One of my readers queried, what is the advantage of bonus shares or stock splits? A good question. Businesses make profits. Out of the profits, they can do three things. Reinvest in business to earn more. Give dividends to shareholders. Or put the money in reserve to be used for some purpose. Bonus shares are issued by capitalising the reserves in the balance sheet of company. Bonus is like a freebie. A free gift to the shareholder in a certain proportion of original share holdings. To make it more simpler, if I owned 200 shares of ILF&S Investment Managers on 01 Jan 2014, and the company declared a 1 for 2 bonus on 10 Nov 2014, it means I would get 1 free or bonus share for every 2 shares which I own. Now, the company announces a record date for it. Anyone who owns the shares on that particular date is entitled to that freebie. Let us assume the record date decided by the company is 15 Dec. So,on 16 Dec 2014, an additional 100 shares will be credited in my demat account. And instead of 200 shares I will have 300 shares.
There is no free lunch. Bonus shares are issued by cashing in on the free reserves (accumulated profits) of the company. A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital. So you do not pay; and the company’s profits are not impacted.
EFFECTS OF A BONUS ISSUE
A Bonus issue has following effects :-
1. Share capital gets increased according to the bonus issue ratio.
2. Liquidity in the stock increases.
3. Effective Earnings per share, Book Value and other per share values stand reduced.
4. Markets take the action usually as a favorable act.
5. Accumulated Reserves get reduced.
6. A bonus issue is taken as a sign of the good health of the company.
7. The debt to equity ratio becomes better as equity balloons. But profit earned remains same.
8. It increases the liquidity of stock. More number of shares are available for buying and selling int he market.
9. Technically it does not make a material difference to the share valuations. The market capitalization stays same or value of business stays the same. How? Earlier you had 200 shares at Rs 60 each. Now you have 300 shares and price readjusts to Rs 40 each. So you had Rs 12000 pre-bonus and you still get Rs 12000 post-bonus.
It is like a banana. I divide it into two and eat both pieces. Does it fill my tummy more? I don’t think so. But psychologically it makes me feel better. I have more of the same shares.
Two types of companies give bonuses. The Good and the Bad. The Bad give bonuses to make their ratios look better to public and FIs. Reliance Power first f@#$d the shareholders with an exorbitantly priced IPO and then gave a bonus. For a good company , a bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. So, ILF&S Investment Managers was giving a dividend of Rs 1.50 per share pre-bonus. I got 200×1.50=Rs300 as dividend. Post Bonus the company gave Rs 1.30 per share as dividend and gave 300×1.30=Rs390 to me as dividend.
Case Study : WIPRO Bonuses
Bonus shares, in the long run would create enormous wealth for the investor. For example, a Rs 10,000 invested in Wipro in 1980 would have grown into several Crores as shown below:-
In 1980 You buy 100 shares @ Rs 100 per share in your name . In 1981 company declared 1:1 bonus = you have 200 shares
In 1985 company declared 1:1 bonus = you have 400 shares. In 1986 company split the share to Rs. 10 = you have 4,000 shares
In 1987 company declared 1:1 bonus = you have 8,000 shares. In 1989 company declared 1:1 bonus = you have 16,000 shares
In 1992 company declared 1:1 bonus = you have 32,000 shares In 1995 company declared 1:1 bonus = you have 64,000 shares
In 1997 company declared 2:1 bonus = you have 1,92,000 shares. In 1999 company split the share to Rs. 2 = you have 9,60,000 shares
In 2004 company declared 2:1 bonus = you have 28,80,000 shares. In 2005 company declared 1:1 bonus = you have 57,60,000 shares
In 2010 company declared 2:3 bonus=you have 96,00,000 shares.
Share price of Wipro is Rs 558.00 on 13 Nov 14. The value of 57,60,000 shares is 535.68 Crores. Did I hear OMG??? Love you darlings….There goes my chalet and Masseratti.