More about stocks - stock bonuses and rights issues
Oran Hall, Personal Financial Advisor
Last week, we looked at dividends, one way that companies distribute profits to their shareholders. This is a payout of cash, but companies may make a distribution to shareholders without paying cash. In this case, they make the distribution in the form of additional stock, or shares.
The rules applying to who receives a cash dividend basically apply when determining who qualifies for a bonus of shares, that is, the shareholders who qualify are those who are on the shareholder register at the record date, but the stock trades without bonus, or X bonus, four business days prior to the record date.
Profitable companies, particularly those with a strong shareholder's equity comprising retained earnings and capital reserves - in addition to the share capital - are best able to pay stock bonuses. Shareholders are allocated new shares proportionate to the shares they own as shown on the register of shareholders at the record date.
By way of illustration, if the bonus is one for four, it means that a shareholder gets one new share for every four shares owned, thus increasing the amount of shares owned from four to five.
In a nominal sense, the bonus issue affects the market price. If, for the sake of discussion, the price of the stock before the bonus was $10, meaning that four shares would be worth $40, after the bonus, the price of each share or unit of stock would be $8. Thus, the market value of the investor's holding of stock would remain at $40.
Balance sheet juggling
This does not make the shareholder any richer. Neither does it change the financial position of the company. It only causes a juggling of the balance sheet. The issued and fully paid share capital of the company increases while another element of the balance sheet, retained earnings, for example, reduces correspondingly.
In many instances, news of the issuing of bonus shares, which involves no payment of money by the shareholder, causes the demand for the stock to increase thus leading to an increase in its market price ahead of the payment of the bonus, so the new owner gets the bonus shares, but the former owner does not necessarily lose from not getting the new shares due to the price adjustment by the market before the bonus.
One advantage to the market is that the increase in the supply of shares on the market makes the stock more liquid; thus, it is easier to buy and to sell it. But if investors flood the market with the new shares, this action may lead to a decline in the price of the stock.
Another advantage is that if the company maintains the dividends paid on each unit of stock, shareholders benefit in the sense that they earn cash dividends on a larger amount of stock.
Rights issues do not constitute a distribution. In fact, they require rights holders to pay to get additional shares so the company really uses this means to raise money and increase its capital. An issue of rights to the existing shareholders of a company entitles them to buy additional shares directly from the company in proportion to their existing holdings, within a fixed time period.
The subscription price of the new shares is usually at a discount to the current market price and the shareholder may choose to sell them on the open market. Although each share entitles a shareholder to one right, the company determines how many rights are required to buy one new share at the subscription price.
Because rights have an expiry date, it is prudent for shareholders who opt not to exercise their rights to sell them on the market. Shareholders who exercise their rights do not experience a dilution in their share of the equity of the company. So if they owned two per cent of the company before the rights issue and exercised their rights, they would still own two per cent of the company thereafter.
This is also true of shareholders who benefit from bonus shares. The primary difference is that shareholders who are entitled to a bonus cannot renounce their bonus.
These are two of the ways in which investors can increase their holdings of shares without going to the market, and they can help in growing investor wealth especially over the long-term.
Oran A. Hall, a member of the Caribbean Financial Planning Association and principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. Email firstname.lastname@example.org