Stock splits generally have a positive connotation. That’s because when something is split, be it a banana, an atom, or a share of stock, you generally wind up with more items than you started with, even if each one is a bit smaller than the original. And, as far as stock is concerned, who wouldn’t want to have more shares?
On the other hand, no one is happy to lose something. Not a wallet, or a key, or a share of stock. Therein lies the dichotomy inherent in the phrase “stock split.” When a company declares a traditional forward stock split” the investor winds up with more shares, but when there is a “reverse stock split” everyone’s holdings are reduced. So it is not enough to know that a company is splitting its shares. The key is how, and why.
Splitting Forward
A forward stock split is generally positive news for investors. Companies split their stock when share prices are high, and usually, when business has been good and share prices are high. In a forward stock split the company multiplies the number of outstanding shares – most commonly by ratios of 2-for-1, 3-for-1 or 3-for-2. But any formula can be used.At the same time that the number of shares is increased, the price per share is decreased by the same proportion. Here’s what happens. Say the company announces a 2-for-1 stock split effective August 2nd. When August 2nd rolls around the shareholder receives an additional share of stock for each share that he or she owned on August 1st. What happens with the price? Let’s say that the stock was trading at $20 a share on the day before the split. When the split becomes effective, the stock price would be cut in half (to $10 per share) in order to compensate for the fact that the number of shares issued has just doubled. The value of the investment remains the same, but now the investor owns twice as many shares.
Why do company’s split shares? Again, forward stock splits generally occur when stock prices are high. Sometimes potential investors are deterred by those high prices and may be reluctant to buy shares because they feel that there may be a limit to the upside profit potential. After a split the stock price is reduced, and the upside becomes more inviting. And new investors have an opportunity to establish a more substantial position, since lower prices permit them to buy more shares than before. It may be purely psychological, but investors often believe there is more opportunity for upward movement when the stock price is reduced.
At the same time existing investors welcome a forward stock split since they will now own more shares of a company they already liked and supported. They too welcome the potential upside – and the opportunity to see their profits increase geometrically now that their holdings have increased.
Finally, a forward stock split can have a positive impact upon liquidity since lower stock prices may narrow the spread between the bid (the price at which brokers offer to buy shares) and the ask (the price at which brokers offer to sell shares).
Going In Reverse
But if forward stock splits signify positive feelings, reverse splits have quite the opposite effect. After all, at the end of the day, the investor has fewer shares.A reverse split is something of a misnomer. After all, how can it be a split at all if you wind up with fewer items rather than more?
How does a reverse stock split work? In this case, the company decides to reduce the number of outstanding shares. The formula can vary. A reverse split may be as little as 1-for-2 or it could be much higher, like 1-for-100, 1-for-200, or even more. When the number of outstanding shares is reduced, the per share price is increased proportionally.
So, let’s say there is a 1-for-100 share reverse stock split effective on August 2nd. That means an investor who owned 100 shares on August 1st would be left with just one share on August 2nd. If each share was worth 2 cents on August 1st, the per share price would be multiplied by one hundred the following day. That means shares would now be $2.00. At least for the moment.
Reverse stock splits can be bad news for investors because they generally signify that a company has problems. Companies don’t reverse split – and increase the outstanding shares – when stock prices are high. And if those stock prices are low, they generally reflect concerns or problems with the company’s financial condition or business prospects – or both. Consequently, while stock prices may be inflated as a result of the reverse split, that effect may be only temporary. Before long the investor may find himself with fewer shares trading at lower prices. The ultimate lose-lose proposition.
If that’s the case, why do companies declare reverse stock splits? In some cases, necessity is truly the mother of this invention. The company may need to maintain a minimum stock price in order to stay listed on a national stock exchange. The NASDAQ Small Cap Market, for example, will delist companies that fail to maintain a minimum price of $1 per share. But while a reverse split can get a company’s shares back to that $1 level, it can’t keep it there. As a result, a company may go through this exercise more than once.
Other companies may declare a reverse split because they want to reduce the number of outstanding shares. Of course, this typically happens after that same company first has flooded the marketplace with stock by issuing oodles of shares to employees, consultants, promoters and financiers. Then the company seeks to reduce the outstanding shares – sometimes so they can simply begin the process again. The stockholders are just along for this ride.
Stock Patrol readers have seen the effects of reverse stock splits. For example, Infotopia, Inc., declared a surprising 1-for-200 reverse stock split on June 21st. While stock prices initially increased to reflect the reverse split, they soon plunged far below their pre-split levels (See Update, Infotopia, Inc. – Split Decisions. And for some other companies that have experimented with reverse stock splits, read Hydro Environmental, Inc. – Westward Ho Hydro; Why?: The Adventures of American Champion Entertainment, Part II – Roddy For Prime Time; and F2 Broadcast Network, Inc. – Spamming the World).
State corporate laws govern reverse stock splits. And states like Nevada - which is home to so many undercapitalized, under performing, emerging growth companies whose shares are traded over-the-counter – do not require stockholders to approve of a reverse split in advance, or to receive prior notice after the company has decided on a reverse split.
Think of it this way, if a forward split is a cause for optimism, what is the reverse?
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