How Reverse Stock Splits Are Implemented

The reverse stock split is less popular than the regular stock split, but savvy investors are familiar with this investment strategy that firms implement to increase their share price.

In regular stock splits, a firm intentionally issues additional shares to distribute to its shareholders at a lower price. With stock splits that occur periodically, small investors can acquire expensive shares of large corporations that would, otherwise, be beyond their budget.

A reverse stock split is, in effect, the opposite strategy of regular stock split. In regular stock splits, one share increases the number of shares by being split into multiple shares. In reverse stock split, one share decreases the number of shares by being split into fewer shares. Hence, with reverse stock split, firms reduce the number of shares outstanding and increase their share price without increasing or decreasing their market value. In effect, the price is adjusted to the ratio of the reverse split. For instance, if the share price is $2 before the 10/1 reverse split, each share will have a value of $20 after the reverse split. An investors that holds $1,000 shares of $2 per share before the split will hold $100 shares of $20 per share after the split. Therefore, the total market value will be $2,000 before and after the reverse stock split.

The reverse stock split is implemented when the price of a stock has declined sharply and a firm needs to avoid being delisted for violation of the minimum-price rules of $1 per share on NASDAQ ( www.nasdaq.com/ ) or New York Stock Exchange ( www.nyse.com/ ). The most recent example of firm that used reverse stock split to avoid being delisted is American International Group ( AIG ) that did a reverse stock split of 1/20 in 2009. Today (as of 06/04/2010 ), its shares trade for $34; before the reverse split they traded for less than $2.

Besides meeting listing requirements on major stock exchanges, firms have other reasons to do reverse stock splits. One reason is that demand is limited for particular stocks that trade for under $5. This makes them unattractive to institutional investors and mutual funds that have set a minimum price for stocks in which they are willing to invest. Yet, with a reverse stock split of 5/1, a share that trades for $2 will automatically trade for $10, which will make it eligible for purchase by institutional investors and mutual funds. Moreover, the $5 price level is widely regarded by investors as the border between companies that issue penny stocks and companies that issue more profitable stocks. In this case, it is a matter of how investors perceive a firm whose shares trade under $5, given that the reverse stock split will have no effect on the firm's market value.

Another reason to implement a reverse stock split is to reduce the number of shares outstanding. As a result of the unrestrained behavior of the market bubble days in the 1990s, many firms have created too many shares outstanding to support stock option and engage in mergers and acquisitions. A reverse stock split is a good strategy to reduce the number of shares outstanding, without affecting the firm's market value.

Finally, many stocks are components of a major stock index and many exchange-traded funds (ETFs) hold the stocks of the index they track. Therefore, if a stock falls too low, it may need to be replaced on the index, which will cause all the funds tracking the stock selling their shares, putting further downward pressure on the share price. A reverse stock split can ensure that the stock has the potential to remain on the index.

Sources:

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

http://www.ehow.com/about_6558415_define-reverse-stock-split.html

http://www.ehow.com/facts_5797970_reverse-split-stocks_.html

http://www.ehow.com/about_6399520_result-reverse-stock-split_.html