Monday, May 01, 2006

Bonus shares - why bother?

The declaration of the bonus can be thought of as recognition of
additional equity capital provided by the investors by virtue of
agreeing to reinvest part of the profits. To understand this, let's
assume that a company X has a equity capital of Rs. 100 crs and no
accumulated profits. The company X earns 20 Crs and pays 5 Cr. as
dividends. Also assume that there is another company Y, which is
similar in all aspect to company X but gives entire 20 Crs as
dividend. Assuming that the profits and all other variables remain
same the company X would have a networth of Rs. 175 Crs. and Y would
have a networth of 100 Crs.

In the year 5 if both X and Y pay 20 Crs dividend which company has
higher payout ratio? same..they both have 100 Cr. equity and they both
pay 20 Crs. However we are ignoring the aspect that the shareholders
of company X have put additional 75 Crs. of capital in the company by
investing part of profits.

If the company X gives a bonus it is recognizing the fact that the
shareholders have provided additional capital by allowing the company
to deploy profits back to the business. This expanded capital base
need to be serviced through dividend and if a company recognizes the
contribution then it is highly likely to raise dividend payout.

All this may sound highly theoretical because the capital structure
doesn't change a bit through bonus. However, empirical evidence
suggests that bonus issues imply higher dividends in longer term. To
that extent the favorable opinion about bonus issues is logical up to
a certain limit.

The reaction of the market is many times exaggerated. Many analysts
seems to overvalue the advantages of more liquidity provided by the
bonus but I think it is of very limited long lasting value. The stock
splits serve the same purpose as bonus as far as liquidity is
concerned but they have no long term consequences.

In economics and finance, the expectation of change of variables is
more powerful factor than the change in variable. The variable in this
case happens to be the dividend. The bonus also raises expectation
that the profits are less likely to fall from current levels because a
conservative management would never like to reduce the dividend payout
even in bad times.

This subject has been nicely explained in the Intelligent Investor by Graham and
you can refer the book for more details.

Posted: Jul 1, 2005