Investing in stocks – Part 5

Some of the most misunderstood events surrounding equities are the matters of bonus shares, stock splits and rights issues.  I have often heard investment analysts argue that when a company issues bonus shares then the value of its shares will increase.   A bonus issue of shares occurs when a company provides its shareholders with additional shares at no cost to the shareholder.  The company is able to do this because it has accumulated reserves which can be used to issue shares. 

For example, if one has 400 shares in Grace Kennedy and a bonus issue of 1 for 2 is declared the then an additional 200 shares will be given to the shareholder.  The shareholder will now have 600 shares and so may think that he has increased the value of his holding.  However, at the time of issue the price may have been $60 and as a result of the additional shares the market price must be adjusted to reflect the new number in issue.  In our case this would adjust the price of $60 by 2/3 to give a new price of $40.  The adjustment represents the ratio of the number of shares held before the issue to the number of shares held after the bonus.  The value of the shares before the issue would be 400 * $60 = $24,000 and the value after the bonus is 600 * $40 = $24,000 i.e. the exact same value.  Bonus shares do not thus increase the value of one’s holdings. 

A stock split is similar to a bonus issue in that it increases the number of shares that the investor has but it does not require the to use of  company reserves.  In our example, the par value of the shares changes from say $1 to 50 cents increasing the number of shares by two.  The market price of the shares has to be reduced so as to maintain the same
total value i.e. stock splits do not increase the value of an investor’s holdings. 

In a rights issues additional shares are available to shareholders but in this case they are required to pay for them.  It is called a rights issue because your holding of the share entitles you to the right to buy additional shares.  If they are issued at a discount the market price will be adjusted downwards to ensure that the total vale remains unchanged.  If all persons do not take up their rights the unclaimed rights can be sold to other shareholders.

Tags: Carl Wilson