A Reverse stock split is not a term commonly heard in the stock market. You could be hearing about straight ‘stock split’s that increase the number of shares after the event. But once in a while companies announce a Reverse Stock Split in a plan to solve some problems.

 A Reverse stock split is not a term commonly heard in the stock market. You could be hearing about straight ‘stock split’s that increase the number of shares after the event. But once in a while companies announce a Reverse Stock Split in a plan to solve some problems.

What is a Reverse Stock Split?

A reverse stock split put simply is opposite of a straight ‘stock split’. A stock split when announced by a company implies that they are planning to increase the number of shares of their company trading on the exchanges. Similarly a reverse stock split is announced by the company for an opposite effect.

When a company undergoes a reverse stock split, its shares will reduce in number. Don’t get scared! Accordingly the price value of each share of the stock will scale up. On overall there will be no difference to the market capitalization of the stock or company. But only the number of shares and their price value that changes.

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How Does it Work?

For example, let us say a company X announces 1-for-5 reverse stock split. That means if you owned 1000 shares of X, after the split, you will have 1000/5 = 200 shares. If the share value was 0.10 before the split, now it becomes 0.10*5 = 0.5.

Before split, capitalization = 1000*0.1 = 100.

After split, capitalization = 200*0.5 = 100.

Though share price increases, the overall capitalization is same before and after reverse stock split.

Why do They Reverse Stock Split Shares?

Typically companies announce reverse splits because of this effect of increasing share price. The stock price may be too low. You will also observe that most of the time reverse splits are announced in huge ratios like 1-for-10, 1-for-20, 1-for-100 and so on. Whereas a normal stock split where shares reduce in price value, are announced most often but for small ratios like 2-for-1, 3-for-1, 4-for-1 and so on.

Normally these indicate bad situations for the company. Hence it should be seen as a warning signal. Just note the ratio. If it is too high, then it is too bad for the company.

It Affects Liquidity Too as a Consequence

This in itself means that the liquidity of the stock changes. Very less number of shares are traded at any time than compared to the time before the reverse stock split. There are also other consequences of a reverse stock split.

How does it Affect a Shareholder of the Stock?

In a normal stock split, shareholders are not affected as the overall capitalization and the total no. of shareholders remain the same. But in a reverse stock split, though the capitalization is same, the no. of shareholders can reduce because there is always a minimum limit on the no. of shares a shareholder should possess, say, 100 shares. Those who have less shares might be given cash and the company buys back those shares.

Most of the times, reverse splits indicate deep trouble in the company. Examples show that even after reverse stock splits, the shares of a company continue to drown further. A shareholder who ignores this warning sign is likely to drown along with it!

Resources:

http://www.investopedia.com/terms/r/reversesplit.asp

http://en.wikipedia.org/wiki/Reverse_stock_split

http://www.businessweek.com/investing/insights/blog/archives/2009/08/reader_mail_doe.html

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