BY AKUL DUA
Now and then, there is a headline in newspaper, ‘XYZ company approved the reverse stock split of its shares of common stock at a ratio of 1-for-X.’ The question which arises is why do companies take such a step and how can it impact the investors.
To start with, let us first understand what a Reverse Stock Split is:
A Reverse Stock split is an action taken by the company to reduce the number of outstanding shares in the market. A reverse split takes a number of shares from the shareholder and replaces them with a smaller number. The new share price is proportionally higher, leaving the total market value of the company unchanged.
Confused about how your shares would be affected due to the reverse split?
Let’s get it covered.
Calculating the effects of a reverse stock split is easy. Simply divide the number of shares you own by the split ratio and multiply the pre-split ratio by the same amount. For instance, say a stock trade at Rs 10 per share, and the company does a 1-for-10 reverse split. If you own 1000 shares, worth Rs 10,000 at current prices, you will get one new share for every 10 old shares you own, or 100 new shares. Immediately following the reverse stock split, the stock price will rise to Rs 100 per share. That will leave your small position in the company still the same amount, as 100 shares multiplied by Rs 100 per share equals Rs 10,000.
WHY DO COMPANIES TAKE THIS STEP?
To prevent its stock from being delisted by boosting its share price
Being listed at a major exchange is considered as an advantage for the company in terms of attracting equity investors. The company stock is at a risk of being delisted from NYSE if the stock price falls below $1 after its initial listing. However, there are no such restrictions in India with respect to share price for being listed at a major stock exchange.
To boost company’s public image
Typically, stocks with a share price in the single digits are seen as risky. Generally, when the share price of a stock fall below Rs 10, the stocks are classified as penny stocks and there is often a negative stigma attached to penny stocks about speculation and insider trading. The companies would always try to avoid this label and protect their brand by engaging in a reverse split.
To get more attention from analysts
A company may also wish to undertake a reverse stock split to attract more attention from analysts and influential investors. High priced stock tends to attract more attention from market analysis and is viewed as good marketing.
To avoid delisting from option exchanges
A company’s share needs to maintain a reasonable share price to be listed on option exchanges. If a company’s stock price falls too low for options to be traded on it, the shares might lose interest from hedge funds and wealthy institutions investors who invest billions of dollars in the market and hedge their position via options.
CRITICISM FOR THE REVERSE STOCK SPLIT
Since every coin has two sides, so does the reverse split. Reverse splits can even have a negative connotation. As previously mentioned, a company is more likely to undergo a reverse split if its share price has fallen so low that it is being danger of being delisted. As a result, investors might believe the company is struggling and will view the reverse split as nothing more than an accounting gimmick.
EFFECT
Hence a reverse split may bring positive or negative news for the investors. A reverse split could signal the financial strength of a company to list itself at a major stock exchange. If you own stock in a small company that has seen increased profits or sales, the stock price should continue to rise after the reverse split. Although you will end buying fewer shares, but they will be worth more as the price continues to rise. However, in certain situations it may boost the stock price for a while, but if sales have stalled or the company posts consecutive losses, the stock will continue falling. Left unchecked the stock would be eventually delisted. Hence the effect of the reverse split is for a short time, while in the long-run nature of the company tends to dominate share price.
FINAL THOUGHT
Reverse stock splits are decided by the management. You as an investor, do not have an option to accept or decline it. But as long as you invest in fundamentally strong companies, you shouldn’t worry about reverse stock splits since it’s merely an accounting tactic. There is no monetary profit or loss in reverse stock splits. As an investor, your goal should be to invest in fundamentally strong companies.
ABOUT THE AUTHOR
Akul is a student of Kirori Mal college currently pursuing B.Com. (H). He has a keen interest in finance and economics and wishes to explore these fields. Learning about things always fascinates him, and he looks forward to make use of his knowledge in the most creative ways possible. He is an optimistic personality who aims to make it big in life.
Disclaimer: The views expressed in this article are the author’s own and do not necessarily reflect the views of the organization.
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