Understanding Reverse Stock Split

The term refers to corporate performance in which a firm’s outstanding shares are being reduced. A reverse stock split engages the firm in dividing its current shares into at least 5 or 10, and will be called a 1-for-5 or 1-for-10 split, respectively.

The opposite of a reverse stock split is a conventional stock split is, in which the number of shares outstanding is increased. Either forward or reverse stock split, it does not add real value to the firm. However, they both differ in the motivation in which the price of the stock moves after a reverse and forward split can possibly be divergent. A reverse stock split is well-known as either “stock consolidation” or “share rollback.”

For example, a 200 million shares outstanding is owned by a company which has a price of 20 cents per share, a 1-for-10 reverse split will cut the number of shares into 20 million, while the shares must be traded at around $2. Keep in mind that both pre-split and post-split of the firm’s market capitalization should be set and remain at $40 million.

Furthermore, in reality, a stock which went through a reverse split could possibly undertake renewed selling pressure. For example, after the reverse split and the stock’s price went down to $1.80, the firm’s market cap would settle at $36 million. On the other hand, with a forward split, as the stock is expected to be successful and a lower price which caught investors’ attention, the stock is possible to gain.

In most cases, a reverse split is carried out in order to have a successful exchange listing requirements. In an exchange, for a stock to be listed, it basically specifies a minimum bid price. On the other hand, if the stock made a below decline in the bid price, the risk is to be delisted.

Taking exchanges suspend the minimum price requirement for the mean time amid uncertainties. For instance, during the 2008-09 bear market, the NYSE along with Nasdaq suspended the stock’s minimum $1 price requirement.

Conversely, during normal business times, a company’s stock price which has a strong decline over the years have little choice but to go through a reverse stock split in order to continue its exchange listing.

Another advantage of a reverse split is that reducing the shares outstanding and share float make stocks difficult to borrow. Thus, it will be difficult for short sellers to short the stock. The bid-ask spread may be widened by the limited liquidity, which in turn puts off trading and short selling as well.

The ratios of reverse splits are basically higher than forward splits, with certain splits made on a 1-for-10, 1-for-50 or even 1-for-100 basis.

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