You are in a newly formed gourmet pizza club. When you joined, each slice was worth $1.50 and you have acquired eight slices worth $12. The club founders feel that $1.50 is not a fair value for their slices and they want to raise the price to $3 per share. In response, they recall four of your slices, but in return, they make each of your remaining slices worth $3 per share. The market value of your membership hasn't changed and the founders can move forward charging new members the new, higher price.
This is the general principle of what happens in a reverse stock split. An investor sees their number of shares decrease while the stock price of each share increases. This is different from a traditional stock split in which an investor receives more shares with each share being worthless.
However, where a traditional stock split is generally welcomed by the investment community, reverse stock splits tend to have the opposite effect. Many analysts and industry professionals find the practice to be an indication of trouble.
The question is one of intent. Our pizza example was silly, but the question that you might ask as a consumer is why would you want four slices when you could have the eight regular slices? It’s the same thinking with a reverse stock split. You’re accepting a lower ownership stake in the company you’re invested in, but your individual shares are worth more. So why would a company do it?
That question and more will be the focus of this article. We’ll define a reverse stock split and provide examples of how they work and how they impact share prices. We’ll also review the reasons why companies engage in reverse stock splits and why they generally receive a negative perception with industry analysts.
What is a reverse stock split?
A reverse stock split is a deliberate corporate action where a company reduces the number of outstanding shares in the market while increasing the price per share by a proportional amount, therefore, keeping the market value of the shares the same.
The practical example of this is somebody giving you a single $100 bill in exchange for two $50 bills. You haven’t lost any value. However, if each share represents an ownership stake in the company, you would have a proportionately lower ownership stake in the company. Let’s look at a reverse stock split from the point-of-view of a company and an investor.
First, let’s look at it from the company’s perspective. If a semiconductor manufacturer has 4 million outstanding shares valued at $3.00 per share, they have a market capitalization of 12 million dollars (market capitalization is a simple calculation of outstanding shares x price per share). However, the company feels their shares are undervalued and they are noticing less interest from buyers as their share price continues to decline.
In response to their situation, they issue a 1:2 split. This halves their outstanding shares from 4 million to 2 million and increases the value of those shares to $6 per share. Their market capitalization remains at 12 million dollars. They have accomplished their objective of boosting the price of their stock without changing their market capitalization.
Now let’s look at this from an investor’s perspective. If an investor owns 500 shares of the semiconductor company at $3 share, the market value of their shares would be $1,500. After the reverse split, they would now own 250 shares worth $6 per share. The market value of their portfolio would still be $1,500.
Like a traditional stock split, a reverse stock split can be just about any proportion. In our example above, a 1:2 split means that a shareholder will have 1 share for every 2 shares they own. If the split was 1:5, it would mean that a shareholder will have 1 share for every 5 shares they own. However, in this case, the price of each share would increase by a multiple of 5. When a company is engaging in a reverse stock split to boost their share price to a point that will keep it listed on an exchange, they may intentionally issue high multiple splits like 1:5 or 1:10.
How does a reverse stock split work?
In a reverse stock split takes place in two steps. First, the company cancels its outstanding shares. It then reissues new shares in proportion to the ratios of the split. So if they are conducting a 1:5 split, shareholders will receive one share for every five shares they previously owned. However, each share will now be worth five times its original value.
But a company has to follow a strict, and somewhat expensive, process before a reverse stock split can go into effect. In the first place, a company must document their intention to take this action with the stock exchange that they are traded on. When the company submits its detailed filing, they must indicate whether this action was voted on and approved by shareholders or by the company's board of directors. Other details that are required in the filing are the split ratio (i.e. 1:2, 1:5, etc.), how the volume of outstanding shares and par value of the stock are affected, and if there are any amendments to the company articles of incorporation. The NYSE charges an application fee of $15,000 for reverse stock splits.
The NASDAQ exchange requires that the documentation is filed a minimum of 15 days in advance of the split. This is done to prevent any confusion in the market that can be caused when an investor would see a price at one level a day before the effective date and a significantly higher price the next day. By being notified in advance, the NASDAQ knows to add a “D” to the company’s stock symbol for 20 days, beginning with the effective date. When investors see the “D”, they know that the price change was due to a corporate action and not because of the company’s performance or market conditions.
Although there is no official limit to how many times a company can execute a reverse stock split, in practical terms they are rare. This is because the major exchanges require a minimum number of outstanding shares to stay listed. In the case of the NASDAQ, the minimum requirement is 500,000 shares. In the case of the NYSE, the minimum requirement is 200,000.
Why does a company issue a reverse stock split?
There are three primary reasons a company would choose to issue a reverse stock split.
- To maintain or obtain a listing on a major stock exchange– For some start-up or penny stock companies, their stock price may be having trouble reaching a level that would give it the credibility to be listed on a major exchange. Other companies may run the risk of being delisted from an exchange if their price per share drops below a certain level.
- A company perceives their stock is being manipulated by speculative trading – Sometimes institutional investors have designs on taking a more active role in a company, or they may be acting in the interest of a third party with designs on orchestrating a hostile takeover. In this case, a reverse stock split can reduce liquidity. The higher price may discourage buying activity and smooth out the volatility.
- The stock is trading below others in its sector– Although this is more of a psychological reason, if a company’s stock is trading below others in its sector, it may be a sign to investors that a company is not as sound of an investment. For this reason, a reverse stock split can help change the perception of a stock.
Some additional, but subordinate reasons for a reverse stock split include:
Satisfy requirements of institutional investors and mutual funds– Many of these companies have policies that restrict them from buying or selling securities if their price is below a minimum value. This minimum price may be above the price required for it to be listed on an exchange. So even though the company may not be relegated to penny stock or over-the-counter status, a reverse stock split may allow it to drive the price to a level where they can achieve the liquidity and status that comes from institutional investors.
Jurisdictional regulations having to do with the number of shareholders– In certain areas of the world, how a company is regulated depends upon how many shareholders they have. Because a reverse stock split reduces the number of outstanding shares it can also help reduce the number of shareholders. This can ensure that a company gets their preferred regulations or laws. Companies that are going from public to private may also look to reduce the number of shareholders.
A company is planning to spinoff an independent company – In this case, a reverse stock split can help ensure shares of the parent company are at an appropriate level so that it has a better chance of pricing the spinoff company at their desired price.
Why are reverse stock splits seen as a bad sign?
To understand why analysts may frown on a reverse stock split, you have to remember that the result of such an action is to intentionally inflate the value of a stock without a company doing anything that would merit the increase. This can be a sign to investors that their stock has been decreasing in value. If a company cannot provide a credible explanation for the decline in price, the reverse stock split can be seen as a desperate, and deceptive, action that belies the company’s true financial position.
The bottom line on reverse stock splits
Reverse stock splits are a corporate action that reduces the number of outstanding shares that a company issues while providing a proportional increase in the value of each share. Thus the end result is that the market value of a shareholder’s investment is the same.
In practical terms, an investor who owns 200 shares of a stock valued at $2 per share would own 100 shares valued at $4 after the reverse stock split. The market value of their stock started at $400 and remained at $400 after the split.
Companies who intend to conduct a reverse stock split have to go through a detailed process with the exchange that they are listed, or desire to be listed upon. This is done in part to ensure that investors can be alerted that the move with the stock is due to a corporate action and not due to the company’s performance or market conditions.
In reality, reverse stock splits are done as a way for a company to maintain a particular stock’s reputation, but there are also practical reasons. For example, if a company is listed on a major stock exchange, they are typically required to maintain a share price of at least $1. As recently as 2009, a couple of major corporations, in the depths of the financial crisis issued reverse stock splits to avoid being pulled from the New York Stock Exchange. American International Group’s stock had fallen below $2 per share, causing the company to issue 1:20 reverse split to boost their share price to $20. Similarly, Citigroup executed a 1:10 reverse split that drove their share price from around $4.50 to about $45.
Because the intent of a reverse stock split is to increase a company’s share price regardless of the company’s performance or market conditions, reverse stock splits are generally met with skepticism by analysts and investors.
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