Understanding Reverse Stock Split

Understanding Reverse Stock Split

Reverse Stock Split as the name suggests is just the opposite of forward stock split where the company decreases the number of shares outstanding in a predefined ratio. For example, if the company’s total outstanding shares are 5,00,000 and it announces a reverse stock split of 2:1 then it would mean that every two shares of the company would be replaced with one share.

But what about your shareholding?

There would be no impact on your shareholding at that moment because the ratio in which shares are cancelled in the same proportion the stock price is increased. That is to say, the above-stated stock, if priced at $2, will increase 2 times to $4, so in this manner, your holding remains unaffected with the decreased number of shares multiplied by increased share price in the same proportion having ‘neutral’ effect.

It may sound fascinating that the share price of the company has hiked to double, but there is another side of the picture.

Reverse Stock Splits are generally undertaken by small-cap companies when falling below the minimum price requirement set by a regulatory body like Australian Securities Exchange (ASX), New York Stock Exchange (NYSE), or Nasdaq. To prevent itself from delisting and align it stock in line with regulatory guidelines, the companies reduce the number of its outstanding shares to take the stock price up in the same proportion.

In such a case, the magic stick of reverse stock split may temporarily raise the stock price to align with regulatory guidelines but later be hit by blood bath with the existing shareholders deciding to sell-off the stock on the news of the reverse split.

However, if the company has proved itself right in the recent past with strong financial performance and attractive returns, the reverse stock split can act as a catalyst to boost the company’s stock price and gain traction from mainstream investors. It is because a higher-priced stock tends to capture more attention from market participants.

Example of a Reverse Split:

Suppose, ABC Limited announces a stock split of 5:1, it would mean that every shareholder of the company would receive one share for every 5 shares they own.

So now say if you own 20,000 shares in ABC Limited that are currently priced at $4.5 per share, your shareholding will be replaced in 5:1 ratio to 4000 shares after the reverse split. Subsequently, the stock price will be moved up in the same proportion, i.e. $4.5 * 5 = $22.5 per share, keeping your shareholding unchanged to $90,000 ($22.5*4000 = 20000*$4.5).

Also, the market capitalization of the company remains the same with a change in the number of shares outstanding to the extent the share price has been revised.

If we look at the past trend, we can see that reverse stock split is most frequently practiced by the penny stocks companies to shrug-off its negative image and the stigma in the over-the-counter market. Biotechnology, technology and energy stocks are few examples of the sectors in which reverse split can generally be seen.


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