ew things match the sheer joy of getting a fat bonus at work.

That is what shareholders of a good company feel when their company decides to throw a few shares (free of
cost) in their direction.

Here's explaining what bonus shares are all about and why investors like investing in such companies.

What's in a share?

Every business has its assets and liabilities.

Assets are the machinery, buildings, land, furniture, stocks, cash, investments, etc. Liabilities are what the company owes other people. Bank loans and money owed to people from whom things have been bought on credit are some examples.

Assets - Liabilities = Capital

Capital is the amount the owner has in the business. As the business grows and makes profits, it adds to its capital.

This capital is subdivided into shares (or stocks). So if a company's capital is Rs 10 crore (Rs 100 million), it could be divided into 1 crore (10 million) shares of Rs 10 each.

Part of this capital, or some of the shares, is held by the people who started the business, called the promoters.

The other shares are held by investors. These investors could be people like you and me or mutual funds and other institutional investors.

• What's in a share? Money!

So how do you benefit?

There are three ways to benefit from buying shares:

1. Selling the shares at a higher rate than what you bought them 

As the company expands and grows, acquires more assets and makes more profit, the value of its business increases.

This, in turn, drives up the value of the stock. So when you sell, you will receive a premium over (more than) what you paid.

This is known as capital gain and this is the main reason why people invest in stocks. They want to make money by selling the stock at a profit.

2. Earning a dividend

Usually, a company distributes to its shareholders a part of the profit it earns as dividend.

For example: A company may have earned a profit of Rs 1 crore (Rs 10 million) in 2003-04. It keeps half that amount within the company.

This will be utilised on buying new machinery or more raw materials or even reduce its borrowing from the bank.

It distributes the other half as dividend.

3. Getting bonus shares

Free shares are given to you and are called bonus shares.

• Make money with shares

What are bonus shares?

They are additional shares issues given without any cost to existing shareholders.

These shares are issued in a certain proportion to the existing holding. So, a 2 for 1 bonus would mean you get two additional shares -- free of cost -- for the one share you hold in the company.

If you hold 100 shares of a company and a 2:1 bonus offer is declared, you get 200 shares free. That means your total holding of shares in that company will now be 300 instead of 100 at no cost to you.

Who foots the bill?

You are right. There is no free lunch.

Bonus shares are issued by cashing in on the free reserves of the company. I mentioned earlier that the assets of a company also consists of cash reserves.

A company builds up its reserves by retaining part of its profit over the years (the part that is not paid out as dividend). After a while, these free reserves increase, and the company wanting to issue bonus shares converts part of the reserves into capital.

So you do not pay; and the company's profits are not impacted.

• How to check if a stock is worth buying

Will the price change after a bonus issue?

A bonus issue adds to the total number of shares in the market.

Say a company had 10 million shares. Now, with a bonus issue of 2:1, there will be 20 million shares issues. So now, there will be 30 million shares.

This is referred to as a dilution in equity.

Now the earnings of the company will have to be divided by that many more shares.

Earnings Per Share = Net Profit/ Number of Shares

Since the profits remain the same but the number of shares has increased, the EPS will decline.

Theoretically, the stock price should also decrease proportionately to the number of new shares. But, in reality, it may not happen.

That's because:

i. The stock is now more liquid. Now that there are so many more shares, it is easier to buy and sell.

ii. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future.

A bonus issue is taken as a sign of the good health of the company.

When a bonus issue is announced, the company also announces a record date for the issue. The record date is the date on which the bonus takes effect, and shareholders on that date are entitled to the bonus.

After the announcement of the bonus but before the record date, the shares are referred to as cum-bonus. After the record date, when the bonus has been given effect, the shares become ex-bonus.

• How to invest in an IPO

So how does a stock's price change after a bonus announcement?

Let's take a few recent examples:

The record date for Matrix Labs'  4 for 1 bonus was January 13, 2005. At the time, the stock price was around Rs 2,116.

Ex-bonus, the stock adjusted to Rs 423.

Note: Rs 423 is Rs 2,116 divided by 5, which is entirely appropriate becaause there are now 5 stocks where there used to be 1.

Or take Aftek Infosys [Get Quote], which gave a 1 for 2 bonus on January 27, 2005. The stock was Rs 109, falling to Rs 73 ex-bonus.

Note again how Rs 73 is exactly two-thirds of Rs 109. But while the stock price of Aftek Infosys rose substantially prior to the bonus, Matrix Labs had not.

Glenmark [Get Quote] Pharma's 1:1 bonus on March 4 saw the stock correcting from Rs 593 to Rs 296.