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True nature of bonus shares

Bank of Valletta recently issued the preliminary statements covering the annual results for the year ending September 30. Among other matters, the board of directors recommended a bonus share issue of one share for every nine shares held.

The bottom line is that no monetary bonus is actually paid out through a bonus share
- Karl Micallef

This means that if this recommendation is approved at the next annual general meeting, a shareholder who currently holds 900 ordinary shares will be allocated a further 100 shares and therefore his new holding will be 1,000 ordinary shares. It was the generic reaction of investors to this action (rather than the action per se) that prompted this article.

Before moving on to the true meaning of these bonus shares it would be appropriate to understand some structures and mechanics. The life of a company typically starts when capital is committed to a new corporate entity. If nothing else is done, the value of the company is the cash transferred into its bank accounts. If the company issues 100 shares and the amount of cash transferred into its bank accounts is €500, then the value of each share is €5. These 100 shares could be owned by one person or 10, the value remains the same and more importantly, it is these 100 shares which make up 100 per cent of the share value. Therefore whoever owns these 100 shares owns 100 per cent of the company.

Let us fast-forward by a couple of years during which the company started its operations, made a small loss of €50 in the first year and a substantial profit of €300 in the second year. The impact of these results on the value of the company’s shares is very simple – at the end of the first year, the share value drops from €5 to €4.50 (€500 less €50 divided by 100 shares). At the end of the second year, the share value rises from €4.50 to €7.50 (€500 less €50 plus €300 divided by 100 shares). In the company’s capital structure we would find the original €500 invested (shareholders’ capital) plus the profits or losses accumulated over the years (retained earnings) – assuming no dividends have been paid out.

The value of the company is a function of the number of shares in issue and the share price. In this example, this would be 100 shares multiplied by €7.50. At this point several corporate actions can be proposed. Issuing bonus shares is one of them. The description of this action can be misleading (bonus share) – one needs to remain focused on the total value of the company and on the fact that if you own all 100 shares you already own 100 per cent of the company.

The board of directors may decide to issue one bonus share for every two shares already owned. This means that the company will issue another 50 shares taking the total number of shares in issue to 150. This does not mean that the value of the company has increased by 50 per cent, because the total value of the company is still €750.

When such corporate action takes place the market should adjust for this bonus issue by automatically adjusting the price downwards from €7.50 per share to €5.00 per share (€750 divided by 150 shares). Often this adjustment is done. But there are instances when the bonus issue is not fully adjusted for, leaving the underlying shareholders with a small gain. Generally, this in itself should not be an argument used to purchase such shares.

A direct result of such action is the potential increase in liquidity which is sometimes used as an argument in favour of such corporate action because this may reduce an existing built-in premium to compensate for the previous illiquidity. Therefore the theoretical bottom line is that no monetary bonus is actually paid out through a bonus share. This action will see part, or all, of the retained earnings being capitalised within the company’s balance sheet.

The last, but very important point, deals with dividends. Too many times have I heard investors conclude that their dividends will be increased because they now own more shares as a result of the bonus shares. This is not the case.

A company can pay out higher dividends if a) it increases pro-fits; b) it increases its dividend pay-out; or c) pays a special dividend. Simply issuing more shares is not an option. The directors of a company will determine the total dividend to be paid out irrespective of the number of shares in issue. The latter will only determine the dividend paid out per share.

Mr Micallef is an executive director at Curmi and Partners Ltd.

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