Stock splits can be of the usual variety or they can be reverse splits. In either case, the number of outstanding shares as well as the price of each share will dramatically change. Reverse splits can also have other ramifications for the long-term viability of the issuing firm.
A regular stock split occurs when the shares in circulation are replaced be a larger number of new shares. In a typical two for one split, for example, 1 million old shares of the firm would be replaced by 2 million new ones. The ratio of new shares to old ones is referred to as the split ratio. In our example, that ratio is two.
In a reverse split, the number of shares declines. A two to one reverse split would take the previous share count of 1 million down to half a million, for example. Whether the split is of the conventional variety or a reverse one, there is no effect on the profits or the cash position of the firm. However, a reverse split can still be good, because it can provide other indirect benefits to a struggling firm.
In a regular stock split, the share price goes down. In a reverse split, however, the share price will go up. Here is why: the firm's profits, asset base or cash position do not change in any kind of split, but the number of shares, which represent slices in a pie, do. If a firm whose market value was around $1 million has 1 million shares outstanding, you can expect each share to trade at around $1. After all, if you own one share you are owning one out of 10 million slices, where the whole pie is worth $10 million. When a 10 to one split reduces the share count to 100,000 each share would be worth about $10. Again, the pie is the same as before, but the size of a slice has grown 10 times. It is this increase in share price that is good for the firm.
Most stock exchanges such as the New York Stock Exchange require share prices to be above a minimum. Shares whose prices fall excessively can be removed from the exchange. Since a reverse split will boost the stock price, it can help a firm stay in an exchange. Firms whose stocks have dropped far enough to face such a danger will likely have gone through tough times, of course. A reverse split does not address the underlying financial issues but avoids the additional problem of the firm's stock being removed from the exchange. Such a removal will usually reduce the stock price even more, making it hard for the firm to raise cash by selling shares.
A reverse split also helps the issuing firm overcome the stigma that comes with a low share price. If the share prices of all competing firms range between $15 and $20 and only one stock in the peer group is trading at $2, this wide gap might make investors nervous. The reverse split will not remedy the true problems. But, at the least, it can prevent the firm sticking out like a sore thumb among peers.
Certain institutional investors, such as mutual funds, are prohibited from investing in stocks that trade below a minimum price. A reverse split may help put the stock on the radar of such investors and is therefore a good thing.
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