A bonus share is a stock that a company issues to existing shareholders without them having to pay any extra. These bonus shares, or “scrip dividends” or “capitalization issue,” are distributed to shareholders according to their shareholdings. A bonus share is a bonus stock that is issued in 1:1 proportion. This means that a 100-shareholder shareholder will be given 100 bonus shares. That would make their total ownership of 200 shares.
A company can distribute profits to shareholders through bonus shares. The company will issue bonus shares instead of paying out cash dividends. This increases the number of shares in circulation. While bonus shares don’t provide immediate cash flow to shareholders, they could have substantial benefits over the long term.
What are Bonus Shares?
A company can issue bonus shares when it converts its retained profits into share capital. Capitalization of profits is the process by which profits are distributed to shareholders as cash dividends or reinvested in the company. The company can decide to keep the profits. It can then add the earnings to its reserves. These funds have been accumulated, and the company holds them for future use. The company can use these reserves to issue bonus shares.
- IPO Basics: What is an IPO and How Does It Work?
- Understanding Dividend: Definition, Meaning, Types, and Importance
- Understanding Stock Dividends: Definition, Types, and Benefits
- Understanding Cash Dividends: What are They and How Do They Work?
- Understanding Property Dividends: What Are They and How Do They Work?
- Understanding Scrip Dividends: Definition and Types
Bonus shares are an increase in share capital. However, the company’s total value does not decrease. If a company holds 1,000,000 shares with an aggregate value of $10 million, each share would be worth $10. The company can issue bonus shares at a ratio of 1:1, which will increase the outstanding shares by 2 million. However, the company’s total value will not change from $10 million to $10 million. The value of each share will therefore be reduced by half to $5. The bonus shares holders will own more of the company, but their shareholding will not be affected.
Benefits of bonus shares
- Higher Liquidity. Bonus shares increase outstanding shares, which increases the stock’s liquidity. This increases the trading volume and the number of potential buyers and sellers. Investors will find it much easier to purchase and sell shares. Institutional investors may also be more attracted to the stock because it has a higher liquidity.
- Cash reserves retained. Bonus shares allow a company’s profits to be distributed to shareholders without depleting cash reserves. Cash reserves are required to pay cash dividends. When a company issue bonus shares, however, its cash reserves are converted into share capital. This leaves no cash reserve for the company. If the company wants to keep its cash and avoid borrowing to finance its future growth, this can work in its favor.
- Shareholder value can rise. Bonus shares may increase a shareholder’s stake in a company. Companies issue bonus shares to increase the number of outstanding shares but maintain an equal ownership percentage of shareholders. A shareholder that receives bonus shares can now have a more significant number of shares. This could increase their stock price investment’s value.
- A positive signal to the market: Investors and traders can see the issuance of bonus shares as a positive sign. This signal is positive for investors and the market. It shows that the company has enough reserves to pay its shareholders while indicating its profitability. Investor confidence can be increased by this positive signal, which could increase stock prices.
There are some disadvantages to bonus shares:
- Diluted Ownership: Bonus shares can increase the share count, diluting existing shareholders’ ownership. If the stock price stays the same, each shareholder will lose a proportion of their ownership. This can lead to a decrease in value.
- Incorrect Interpretation of Performance: Bonus shares may lead to misinterpretation of the company’s financial performance. Bonus shares can give the illusion that the company is growing in financial metrics like earnings per share (EPS) and return on equity. This growth, however, is not due to actual company performance but merely an increase in outstanding shares.
- A negative effect on dividend yield: The issuance of bonus shares may hurt a company’s dividend yield. Bonus shares don’t provide immediate cash flow for shareholders, so the company might have to decrease its cash dividends to keep its dividend payout ratio. Investors who depend on income from cash dividends may find this a problem.
- Administration Costs: Issuing bonus shares can have high costs, such as legal and accounting fees. If the company’s insufficient profits, these expenses can decrease the benefit of issuing bonus shares.
- Restrictions on issuance: There are restrictions in place by certain countries or regulatory agencies regarding the issuance of bonus shares. In India, for example, bonus shares can only be issued if the company meets specific reserve and profitability requirements. The issuance of stock is subject to similar regulatory requirements in America. These regulations could have financial and legal consequences.