The proposal to issue bonus shares is a tacit admission by Reliance Power that its IPO was overpriced. But, the real reason behind the move may be to save the proposed IPO by the group's Reliance Infratel. By Vivek Sharma

A couple of months back, a small property developer in a southern metro ran a full page advertisement for a new apartment complex he had just launched. 'Buy a 3 bedroom apartment, get a Maruti SX4 absolutely free!!'

The property was priced at Rs3,500 a square feet, or Rs49 lakh for each 1,400-square feet apartment. Comparable apartments from other builders in the same area were being offered at Rs3,000 per square feet or a total cost of Rs42 lakh. The difference of Rs7 lakh is slightly more than the ex-showroom price of the SX4 base version, which is what the builder was offering. The road tax, insurance and other costs were the buyer's problem.

There was nothing 'free' in the offer; the builder inflated the price to include the cost of the car. One would have expected potential buyers to see through this 'fantastic offer', but that was not the case. The builder sold more than three-fourths of the property in two days flat

We all love free stuff. We get excited when something is free, even when we know that it is not 'really free' and we are actually paying at least a part of the cost. We all know that there are 'no free lunches', but we all suspend reason and opt to get excited whenever we see a 'free offer'.

In the consumer's perception, a free offer makes the deal much cheaper. Investors generally do not think like consumers and get excited when assets are actually getting costlier - when share prices and property prices go through the roof. Investors will be scared to buy when there is a fire sale, when assets sell at a deep discount to their inherent values. There are investors, like Warren Buffet, who do not behave like this. They make a lot of money and become enviable legends.

Investors behave like consumers only when they are offered something 'free' - like bonus shares. The term 'bonus shares' itself is pretty exciting and reinforces the impression that they are free. That is why they bid up stock prices whenever a company announces its intention to issue bonus shares.

Promoters know this and, with a few exceptions, use bonus shares as an effective tool to shore up share prices. The proposal by Reliance Power to issue bonus shares, barely two weeks after listing, should not surprise anyone. The Reliance Anil Ambani group, perceived to be among the most 'stock-market savvy' and 'investor-friendly' business groups, was under pressure after the below par debut of Reliance Power in the stock markets. The group was desperate and what better way than to offer bonus shares, to redeem its image? (See: Reliance Power mulls issuing free bonus shares after sub prime listing)

How is a bonus share 'free'?
When the first reports of the proposed bonus share issue by Reliance Power started coming out last Sunday, television reporters and anchors were excitedly stressing that the bonus shares would be 'free'. Indeed they are free, in the sense investors don't have to pay anything to get them. But they are not exactly free, as the value of the original shares decline proportionately.

For the company issuing bonus shares, it is like transferring money from one bank account to another. Balances in the free reserves or share premium accounts go down, while the share capital account balance increases. Absolutely no change in profits, assets or liabilities!

But, many ratios considered important in investment valuation decline. As the number of shares increase, the book value per share (BV) and earnings per share (EPS) will decline when bonus shares are issued. Ideally, the stock price should correct in direct proportion to the bonus ratio and there should not be any change in the total market capitalisation.

But, the sum of parts - the total value of the increased number of shares in this case - often turns out to be more than the whole. As the number of shares increase, the price per share comes down and creates the illusion that the stock is valued lower, which attract investors. A larger number of shares improves liquidity and makes the stock more attractive to traders. Therefore, bonus shares in general work out to be beneficial to investors.

Promoters' benevolence
Reliance Power says the company is not planning to issue bonus shares to promoters - Reliance Energy and a private company controlled by Anil Ambani. If promoters are excluded, their percentage holding in the company will come down, something not many promoters would be willing to accept. That makes it a brilliant move to improve the promoter group's image as it creates the impression that the promoters are even willing to sacrifice their own profits to protect minority investors.

But, are the promoters really sacrificing anything? No doubt, their holdings after the bonus issue will come down in percentage terms. However, the reduction is not that significant. The promoters currently hold nearly 90 per cent of the company - close to 45 per cent each by the two holding companies. Even if the board decides to be extremely liberal and announces a 1:1 bonus, the promoters' combined stake will still be around 80 per cent. That will still be among the highest promoter holding ratios in large Indian companies, and more than the 75-per cent limit the finance ministry is said to be considering.

A liberal bonus issue will undoubtedly lift the stock price and the promoters will benefit from that. In fact, the value of their holdings after the bonus may even be higher than the value before the bonus proposal - even if they are not getting any bonus shares!

Why this bonus now?
When Reliance Power had a poor listing, many financial newspapers quoted an 'unidentified' Anil Ambani group spokesman who defended the stock's performance. When the IPO opened, the Sensex was at an all-time high. By the time Reliance Power completed the IPO and got itself listed, the Sensex had tanked. Even then, the decline from its issue price of Rs450 was less than 20 per cent when many other frontline stocks had declined more than that - this spokesman argued. If the overpricing of the IPO was ignored, that was a very valid argument.

None of the companies, which saw their share prices decline more than 20 per cent, have announced any steps to 'build investor confidence' and 'rectify their brand image'. They have not announced any bonus issues and are not even considering any such moves.

Is it prudent for company managements to be so fixated by stock price performance? Shouldn't they be focussing on delivering results, which would definitely reflect on stock prices in the long term? Even if bonus shares prop up the stock price for a short while, what will a company do if the market falls later and its share price decline further? Issue more bonus shares?

Reliance Power is still not willing to accept that its IPO was overpriced. It is blaming the market fall and 'inimical vested interests' for the poor stock performance. In fact, the company has filed a formal complaint with SEBI and has urged the regulator to investigate what it calls 'market manipulation'!

Why is Reliance Power so keen to issue bonus shares? Is it because there is yet another big IPO lined up by the group?

Reliance Infratel, the tower business subsidiary of Reliance Communications, has filed the draft prospectus with SEBI for a large IPO. (See: Reliance Communications' subsidiary Infratel files Red Herring draft with SEBI)

Though the pricing is still not known, Reliance Infratel is said to be planning to raise up to $1.5 billion. If that IPO is to be successful, investors should forget the Reliance Power fiasco. That may indeed be the real reason behind this curious move to issue bonus shares!