Learn The Stock Market Lesson – Reverse Splits: Meaning and Purpose
In my previous entry, I began an introduction on stock splits and reasons why companies might decide to perform this. To be better informed for this lesson on reverse splits, it is recommended for you to read my last post about normal stock splits.
A reverse split, as the name applies, has the opposite effect of a normal split. Instead of increasing the number of shares outstanding and decreasing the share price, a reverse split decreases the number of shares outstanding while increasing the price of the stock. This type of split is not looked upon favorably by many investors, partially because the shares of current investors will decrease, causing them to feel like they have less ownership in the company.
If this type of split is not favorable, why would a company issue this? Sometimes, a reverse split is necessary for a company. For example, if company ABC has 10 million shares of stock outstanding but because, perhaps, of a rough year, their stock price has dropped to $0.50 per share. Although smaller investors often seek less expensive shares because they are more affordable, shares that are priced this low are considered highly risky. These shares are also known as penny stocks, which trades at a relatively low price and market capitalization. Because of its high risk, many institutional investors such as mutual funds and insurance companies will most likely avoid these penny stocks.
Many times a company may also do a reverse split to avoid being delisted, which is the removal of a security from the exchange on which it trades due to its failure of meeting listing requirements that includes maintaining a minimum share price.
In this case, company ABC might decide to perform a reverse split:
1) Before- 1000 million shares outstanding X $0.50 per share = 500 million (market value)
2) After- 100 million shares outstanding X $5.00 per share = 500 million (market value)
As you can see, again the market capitalization does not change but the shares outstanding is decreased and the price of each share is increased. In addition, fewer number of shares outstanding tends to be more attractive because the price can rise more quickly on positive news since it will take a smaller number of shares traded to make significant changes to the price.
Last month, in March, Citigroup filed for a reverse stock split to keep its stock price from dropping below $1 per share.
However, be careful about buying a company’s stocks after a reverse split. Unlike a normal split, reverse splits are considered negative events because stock prices often drops immediately after a reverse split.
Tags: citigroup, high risk, market capitalization, mutual funds, penny stocks, reverse split, shares outsanding, speculative, stock market, stock split
