A company’s market capitalisation is calculated by multiplying the total number of outstanding shares by the market price per share. Companies often opt for measures such as stock splits or reverse stock splits to change the composition of its shareholders and number of outstanding shares.
A reverse stock split is a term used to describe a corporate action in which a company decides to reduce the number of outstanding shares by cancelling all its existing shares and distributing new shares to its shareholders. This is done in a way that every shareholder receives in a proportionally smaller number of shares before the split. Working through a reverse stock split example will help to better understand how it works.
Say a company has 1 million outstanding shares with a stock price of $2 per share. This gives a total market capitalisation of $2 million. The company then decides on a 1-for-4 stock split, reducing the total number of shares to 250,000. The company’s market capitalization remains the same, at $2 million, however the value of each individual share increase from $2 to $8. So an investor who previously owned 100 shares at $2 apiece will now possess 25 shares with a share price of $8, keeping the investment amount same as before.
The primary reason of a company deciding on reverse stock split is the regulatory requirements of stock exchanges such as NASDAQ or NYSE. These exchanges have minimum requirements of share price and companies that are on the verge of going below this level (and hence being delisted) exercise reverse stock split to give a boost to their share price, as explained above. However, this is considered as a negative indicator for company’s future performance.
Another factor that may contribute to a reverse stock split is that the company may be trying to change the perception investors have of it. Investors often perceive very low priced shares as poor quality and hence do not significantly trade in such shares. By exercising a reverse stock split, the price per share of the stock increases and investors may then think of the stock as being of higher quality.
So, what does a reverse stock split do? Quite a lot of things. However, the key changes are as follows:
Although there may be different motives behind a reverse stock split, each with different goals in mind, this sort of a corporate action is generally perceived to be as a negative indicator in the minds of investors. However, how the market actually perceives the company’s decision will depend on the company’s other efforts to sustain and increase its profit level.