Reverse Stock Splits Explained

Sometimes, you hear or read terms that you know that you should understand, but you don't really take time to learn it well until circumstance forces you.

One of the stocks I own will be issuing a reverse stock split in about a month.

I understand the math behind this, but I really didn't know what this means. So I took a closer look.

For those of you who prefer to watch a video, here is Jason Frankl of FTI Consulting was interviewed on Bloomburg to help explain (a) what it is and (b) why it might be issued.

First, what IS a reverse stock split?

According to Investopedia.com, a reverse stock split is a reduction in the number of a corporation's shares outstanding that increases the par value of its stock or its earnings per share. The market value of the total number of shares (market capitalization) remains the same.

For Example...
1:3 Reverse Stock Split

Original Price/Share: $2.00
Original # of Shares: 60 Shares

Revised Price/Share: $6.00 ($2.00 x 3)
Original # of Shares: 20 Shares (60 / 3)

The value of each is the same, so...

Why do companies issue reverse stock splits?

Companies might issue reverse stock splits for a couple of reasons:
1. Remain listed on a stock exchange
2. Become more attractive to investing institutions

1. Remain Listed on a Stock Exchange

How does a reverse stock split help a stock remain listed on a stock exchange?

The NYSE and the NASDAQ stock exchanges are the most widely used and consulted stock exchanges in the United States, possibly the entire world.

Both of these exchanges require that companies that they list have share prices over $1.00.

Why?

Amongst other possible reasons, stocks with small share prices are very easy to manipulate. It is easy to buy a lot of shares at a certain high price or short a lot of shares at a low price. Either of these can too easily influence market (buying and selling) behavior.

Plus, there is a certain level of company each stock exchange wants to represent.

If a company's stock price falls below $1.00/share, they generally have between 7 to 9 months to find a way for its share price to recover. If it does not recover on its own, then the stock exchange might require a company to issue a reverse stock split. This would help push its price per share above the minimum level.

2. Become More Attractive to Investing Institutions

Each investing institutions has its own requirements. However, many--if not most--institutions will only invest in companies with stock prices at a certain share price level or above. For the majority of these institutions, this is $5.00/share.

Once investment institutions are willing to buy shares, the demand increases. Often, so does the company's stock price.

Is there a downside to reverse stock splits?

There can be a downside to reverse stock splits.

Often, many investors in the market assume that a reverse stock split implies that the company is in financial trouble. They also might assume that the company is trying to "trick" them into something.

Keys to Consider with Reverse Stock Splits

Reverse stock splits can be bad or good.

It is important that a company makes it clear (communicates) to investors WHY they are doing this.

Are they making an effort to make investors to understand, or is there a lot of double speak? Are they trying to "sneak" it through?

Does the company seem to have a plan? Does this plan seem to be realistic?

So a reverse stock split might be great, or it might be rotten. It is important that you understand what it is. It is also crucial that you understand WHY they are doing it.

Reverse and Research!