Understanding Reverse Stock Split: A Comprehensive Guide

Public companies often take corporate actions based on their strategy and interests. Corporate actions often affect the company’s investors. For instance, bonus issues can help stakeholders collect additional profits. Similarly, dividend issues can help stakeholders collect their part of the profit made by the company. Reverse stock splits are corporate actions that might bring a change in the portfolio of investors. Continue reading to understand what are reverse stock splits in detail.

What are Reverse Stock Splits?

A reverse stock split is a corporate action that reduces the number of existing shares. However, the value of the outstanding shares remains the same. It consolidates all shares into fewer shares, thus increasing the price of a single share. The value of the portfolio does not change for stakeholders. However, the number of shares held by each investor will decrease after a reverse stock split. Outstanding shares are divided by a particular number, say 4 or 10. It is then expressed as a 1-for-4 or 1-for-10 reverse stock split. It means that 10 or 4 shares are merged to form a single share. Also learn what is stock split in the stock market.

Their absence could lead to challenges for buyers and sellers in finding desired assets promptly. They ensure the availability of stocks, derivatives, and other assets as needed, setting quotes for buy and sell orders. Maintaining liquidity involves buying or selling assets, offering bid and ask prices to traders, and profiting from the price differences.

Example of a Reverse Stock Split

Let us take a reverse stock split example for clear understanding. Let us say a company named ‘XYZ’ has issued a total of 10,000 shares. The price for each share on the market is Rs 100. Now, the company has announced a 5:1 reverse stock split. It means that five shares of XYZ will be merged to form a single share. Upon dividing the total number of shares by five, we get 2000 shares (10,000/5). The company will have a total of 2,000 shares held by investors after the reverse stock split. The market value of a single share will not become Rs 500 (100*5).

Reverse stock splits decrease the number of shares held by investors. In the above example, let us say an investor had 50 shares of XYZ before the reverse stock split. In this case, the investor will have a total of 10 shares after a 5:1 reverse stock split.

How Do Reverse Stock Splits Work?

Reverse stock splits are corporate actions taken by directors and concerned board members. The company usually announces the reverse stock split ratio to investors, say 1-for-5 or 5:1. Board of directors also decides upon the record date, for which the eligibility of shareholders is considered. Stocks are divided based on the reverse stock split ratio. Also, prices are adjusted in the market after a reverse stock split. For instance, a company had a total of 5,000 shares at the price of Rs 50 per share. After a 5:1 reverse stock split, the new price will be Rs 250 per share. Trading continues as usual for investors with the new stock price.

Impact of Reverse Stock Splits on Investors

Reverse stock splits affect both existing and new investors in the company. The number of shares held by existing investors will decrease after a reverse stock split. However, the value of their holdings will remain the same. If an investor had shares worth Rs 3,000, the value would remain the same after a reverse stock split. Only the per-share price will increase as existing shares are consolidated. Also, each share will represent a higher ownership stake in the company after a reverse stock split.

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Reverse stock splits might not please new retail investors. Since the price of each share is more after a reverse stock split, retail investors pay more. However, a reverse stock split creates an illusion of increased company value in the market. The value of total shares remains the same, as the fundamentals of the issuer do not change. In some cases, a reverse stock split might decrease the liquidity of shares, as investors might find them expensive.

Advantages and Disadvantages of Reverse Stock Splits

Reverse stock splits have several pros, like prevention from getting delisted. A company might face de-listing risks due to decreased share prices. Since the share price will increase after a reverse stock split, it might save the company from getting delisted on the stock exchange. Every stock exchange has a bid price for all the listed companies. When the market value dips below the bid price, the company is removed from the stock exchange.

Some companies rely on reverse stock splits to attract premium investors. When the stock price increases, it might attract institutional investors and HNIs. Some companies planning to become private entities also rely on it to reduce the number of shareholders. Companies launching their spinoffs can get attractive prices in the market by announcing a reverse stock split. When the parent company has a higher share value, the spinoff entity might get attractive prices.

Even though reverse stock splits have certain advantages, there are some demerits. The share price rises after a reverse stock split, thus making it difficult for new retail investors to purchase stocks. Also, this corporate action is not perceived as a success in most markets. It happens when investors know that the prices have hit rock bottom, and the company is trying to prevent delisting.

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Seasoned investors do not consider reverse stock splits as a special occasion. They know that the fundamentals of the company do not change after a reverse stock split. In some cases, the liquidity of the stock might plummet after a reverse stock split. Since more investors cannot trade shares due to increased prices, the liquidity plummets.

In a Nutshell

Reverse stock splits consolidate the existing number of shares. The existing number of shares is divided by a certain number to decrease the total number. However, the value of total outstanding shares remains the same after a reverse stock split. Companies might go for reverse stock splits to boost the share price or prevent themselves from getting delisted. One can say that it is the opposite of a stock split action. Learn about other corporate actions now!