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Understanding Reverse Stock Splits

9 June 2008 - Features - Editor

A reverse stock split reduces the number of a company’s shares, which in turn increases the earnings per share, while the company’s market capitalization remains the same. This makes the stock appear to be more valuable than before the split, when in fact nothing has changed. There are a number of reasons why a company may choose to undertake a reverse stock split, let’s consider some of them.

Reverse stock splits are seen by many as a company’s last ditch effort to avoid being de-listed on the major stock exchanges. Share prices may have dropped so low that the possibility of being de-listed becomes a very real threat. In this case a reverse stock split, increasing the value of shares by decreasing the number of shares, can save the day.

Even if the stock price is not low enough to be de-listed on the stock exchange, many mutual funds and institutional investors have rules that prevent them from buying stock that is priced below a pre-determined minimum. Should a company’s stock price fall below this minimum, they will be excluded by a large market segment in day to day stock market trading. In this case, a reverse stock split will make their shares more attractive to potential buyers.

A company may use a reverse stock split as a tactic to reduce the number of its shareholders. For example in a 1-for-100 reverse stock split, investors who hold less than 100 shares would receive a cash payment instead of shares of stock. This is sometimes referred to as the investor being “cashed out”.

The board of directors of a company has the authority to declare a reverse stock split without consulting the shareholders. Shareholders will, however, be advised of a reverse stock split. Although the Securities and Exchange Commission (SEC) has extensive authority over corporate activity, reverse stock splits are subject to state corporate laws, by-laws and the company’s articles of incorporation.

Some companies that use reverse stock splits survive and go on to prosper, however, history reveals that stocks tend to trade lower after a reverse stock split. Investors owning stock in a company that undertakes a reverse stock split should heed the warning signs that something significant is brewing within the company. Some research into the reasons for this move will be helpful in deciding whether to hold on to the stock or sell.

 


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