What is A Bonus Share?
A bonus share is a stock issued by a company to its existing shareholders without any additional cost. The number of bonus shares is determined by a ratio, such as 2-for-1, meaning that for every share held, the shareholder will receive an additional two shares. Bonus shares are typically issued to increase the number of shares outstanding and to make shares more affordable for small investors. This is often done to increase the liquidity of a stock and to make it more accessible to a larger number of investors.
How are bonus shares provided?
Bonus shares are offered via a bonus issue. As the first step, the board of directors of the company decides whether they would like to and are in a position to issue bonus shares. Thereafter the proposal is taken to the shareholders for their approval. Once approved, the information is made public and also communicated to SEBI and the RBI.
So, what is a bonus issue, you might ask. Well, the bonus issue of shares is additional shares that a company distributes to its current shareholders. There is no additional cost associated with it, hence the term bonus. Companies may decide to provide shareholders bonus shares as a method of rewarding them or to boost the stock's liquidity. Typically, bonus issues are offered in proportion to each shareholder’s current ownership of the company. So, if the bonus shares being offered are in the ratio of 2:1, and you presently hold 100 shares of the company; then you will be awarded 200 extra shares, taking your total to 300 shares.
What is the eligibility criteria for bonus shares?
The specific eligibility criteria for getting bonus shares can differ slightly among companies. However, usually, a bonus issue is only available to shareholders who own shares of the corporation prior to the record date and the ex-date established by the company. This brings us to two new terms that are worth knowing.
The record date is a deadline established by a company. Investors shall be entitled to bonus shares only if they are shareholders of the company as of the date declared in the bonus issue notice. This mechanism is used by companies to compile a list of all eligible shareholders in order to distribute bonus shares in the pre-decided ratio and inform the shareholders accordingly. Record dates are also applicable in the case of a dividend payout or stock splits.
For the delivery of shares, India has moved to the T+1 rolling settlement system, in which the ex-date occurs 1 day before the record date. So, effectively, to be listed as an owner of the share by the record date (to meet the bonus issue eligibility criteria) the shares must be purchased prior to the ex-date. Unless this happens, you will not be able to receive ownership in time to qualify for bonus shares declared by the company.
Do note, some companies may set forth internal limitations on the kind of shares and segment of shareholders that will be eligible for receiving the bonus issue. As always, it is important to carefully read the terms and conditions of each bonus issue.
What are the benefits of issuing bonus shares?
Let us first look at this from the company’s perspective.
Increased market capitalisation:Bonus shares increase the company’s total number of outstanding shares in the market. This has the potential to increase its market capitalization (m-cap), thereby making it more attractive to potential investors. On the flip side, since the same total earnings of the company are now divided by a larger number of shares. So the earnings-per-share (EPS) may go down which might deter some investors from purchasing shares.
Higher goodwill:Perception can play a big role in investment outlooks. By issuing bonus shares, a company can reward its existing investors leading to an increase in the goodwill generated. Moreover, offering a bonus issue is also a sign that the company is doing well, is financially stable, and has a strong commitment to its shareholders.
Enhanced liquidity:Bonus shares increase the number of outstanding shares, which can improve the liquidity of the stock and make it easier for shareholders to buy and sell their shares.
It is vital to know here that the term ‘bonus’ can be misleading at times. Yes, you get additional shares free of cost in the ratio that has been declared by the company, but there is no net financial gain immediately. This is because the price of the share drops in the same ratio, thereby keeping the overall value the same. Let us understand this.
In the previous example, you received 200 additional shares over the 100 you already had. Now, let us assume that the pre-bonus issue stock price of the company was ₹50 per share. This means the value of your total holding was ₹50 x 100 = ₹5,000. After the bonus issue (2:1) the price of the share will drop to 1/3rd of its original price, which means ₹16.67. Once you receive the bonus shares in your Demat account, the value will still remain the same, i.e. ₹16.67 x 300 = ₹5,000.
So then, what is all the fuss about if there is no direct monetary impact of a bonus issue of shares? Well, the two main benefits that investors can expect to get are:
- Due to the drop in price, you get the chance to buy shares that may have been previously unaffordable. It also becomes easier to trade, increasing the liquidity of your own holding.
- Bonus shares increase your ownership in the company. This can reap benefits when there is a dividend payout or rise in the stock’s price, since you hold more shares now.
So, now you know what a bonus share is and how it works. There is neither any cost nor any tax implications of receiving bonus shares. However, when you sell them, you will need to pay the applicable tax on the proceeds such as Long Term Capital Gains Tax (LTCG) or Short Term Capital Gains Tax (STCG). The real benefits come through appreciation of the price of the stock on the announcement of dividends per share. Thus, bonus shares should, ideally, be purchased with a long-term investment view, and upon careful evaluation of the company’s financial health and operational performance.