Understanding A Reverse Stock Split

A Reverse Stock Split is when a company approves, and takes action to make a reduction in the total number of shares outstanding in the market which in turn increases the new value of each individual share price.

This action can be performed at different exchange ratios, such as 1:2, 1:10, 2:10 etc.

The exchange ratio is most commonly determined and approved by the Board of Directors based on specific company goals. Read additional detail here at the SEC.

Also known as a "Reverse Split", the announcement itself sometimes causes an increase in optimism, at least initially. Let's take a further look:

What happens during a Reverse Stock Split?

As mentioned above, the number of shares outstanding are reduced and the new value of each share increases. Example: XYZ, Inc. has 10,000,000 shares outstanding with a share value of $1.00 each. The company announces a reverse split of 1:10, or 1 new share for 10 existing shares. After the reverse stock split, there are now 1,000,000 shares outstanding with a per share value of $10.00 each.

Prior to the reverse split, 10,000,000 shares outstanding times $1.00 each= $10,000,000 total value of all shares outstanding, or Market Cap. After the reverse stock split, 1,000,000 shares outstanding times $10.00 each= $10,000,000 total value of all shares outstanding, or Market Cap.

You can see that the number of shares outstanding were reduced from 10,000,000 to 1,000,000 and the value per share was increased from $1.00 to $10.00. Notice though that the total value of shares outstanding has stayed the same.

What happens to shares you own during a Reverse Stock Split?

As in the example above, the total number of shares you own will increase, the value of each individual share will increase, and the total value of all of the shares you own will remain the same.

The shares in your account would automatically be converted in number and share price by your brokerage firm. You do not have to do anything to participate in the conversion.

Why would a company do this if the value of the total shares outstanding remains the same?

This is the important question that most people don't ask themselves when a reverse stock split is announced. Here are some possible reasons:

  • Avoid being de-listed because of the share price not meeting specific exchange listing requirements.
  • Give the appearance that the stock is more valuable.
  • Appeal to Institutional and Mutual Fund Investors that often require a minimum share price before being considered for purchase and inclusion in portfolios.
  • Use in conjunction with other actions such as capital raising actions, which would dilute shareholder value and otherwise possibly cause an even lower per share price.

These are of course only some reasons, but they are some of the most common I have seen. Looking at each one of them appears to indicate that the company doing a reverse stock split is not in a very good position. After all, if a stock price has been increasing steadily, none of the above instances would come into play.

What usually happens to a stock price following a Reverse Stock Split?

Short term, an announcement of this type of action usually increases optimism and a rise in share price. This is mostly because a company stock that is in the position to have to take this action has been trending lower for quite some time already and pessimism has been high for quite some time.

It's only natural for an announcement like this, which requires further analysis that most people don't do, to reverse the stock price due to the change from pessimism to optimism, initially.

Longer term though, many stocks that initially rise on the announcement wind up continuing their decline to new low levels. A good example of this is to look at past stocks that have announced and completed reverse stock splits.

As a good example, in March of 2008 Bluefly (BFLY) announced a 1 for 10 reverse stock split (1:10) to take effect in early April 2008. At the time the stock was trading at .46 (46 cents). After the exchange, each new share would be worth $4.60 based on the price at that time.

In the days following the announcement, BFLY went up to the mid 50's (that's cents, not dollars...). So optimism rose causing an increase in the stock price of near 20% based on the announcement alone. Nothing fundamentally changed with the company. Here is a stock chart showing how BFLY has done since the 1:10 exchange:

Reverse Stock Split

You can see that after the 1:10 exchange occurred in early April 2008 near $5.00 per share (.50 before exchange) the stock has continued lower, reaching .32 in December 2008, and is currently near .90 per share. The initial rise in the stock price after the announcement was only brief. Afterwards, reality set in and the realization that the company fundamentals had not changed and the share price resumed it's decline.

Lessons learned:

  • Realize that a reverse stock split is typically the sign of action taken to try and halt the decline in the share price of a stock (not always).
  • Make sure that when you are viewing stock charts that any splits are shown on the chart to accurately analyze past price performance.
  • Do research and analysis into why a company is taking this action before making any decisions.
  • Study examples of stocks that have performed this action in the past, such as the example above, to better understand possible future price movements.
  • For those of you that think a particular stock cannot go down for much longer, think again. You now know that just because a stock is at a low price level of say $1.00 for example, that a corporation can take actions to extend the pain and suffering for existing shareholders for much longer than many realize.

Return From "Reverse Stock Split" To "Stock Trading Strategies"

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