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Reverse Stock Splits Definition and More

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 10/20/2009

During the go-go years of the Internet Bubble, stock splits were very common. As share prices raced every upwards, companies employed splits to keep their share prices lower. Today, that isn’t the case so much. Largely thanks to news about reverse stock split possibilities at Citigroup and AIG.

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    Reverse Stock Split Definition

    A reverse stock split is when a corporation reduces its overall number of shares outstanding by converting a specified number of shares into a smaller number of shares, but with a higher price. Immediately following the split, the total value of the shares is the same. This is occasionally referred to as a split down.

    To understand what happens when a stock splits, or does a reverse split, an example is particularly instructive.

    Assume that a company has 300 million shares outstanding. These shares currently trade at $3 per share. This can cause various issues for a corporation, including possible problems with being delisted from certain stock exchanges that require a minimum price per share value. In addition, a low stock price may give the impression that the company is in trouble and that its stock is not worthy of investment because of the share price. (Note that neither of these is necessarily true.)

    In order to execute a reverse stock split, the company typically must get shareholder approval. Both reverse stock splits and regular stock splits are structured so that current shareholder value is unchanged as a result of the transaction. There are numerous ways a company can have a reverse stock split, including 1 for 2, or 2 for 3, in which current shareholders receive one share for every two shares they currently own, or two shares for every three shares they currently own, respectively.

    The price per share is adjusted to reflect the new number of outstanding shares. The share price is therefore adjusted in an equivalent manner. In a one-for-two reverse stock split, the price of each share would be doubled, while the number of shares would be halved.

    In our example, each share currently trades at $3 per share. If an investor owned 10,000 shares and the company executed a one-for-two reverse stock split, the investor would end up with only 5,000 shares, as opposed to the original 10,000 shares. However, the price of each share would be $6 per share, as opposed to $3 per share. Either way, the investor’s holdings are worth $30,000 at the time of the reverse split.

    (10,000 shares X $3 per share = $30,000 OR 5,000 shares X $6 per share = $30,000)

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    Why Do Companies Do Reverse Stock Splits

    Theoretically, there is no value in doing any kind of stock split, whether a reverse stock split or a forward stock split. Warren Buffet’s Berkshire Hathaway stock, for example, has never under gone a stock split. However, this is an anomaly as Berkshire A shares now trade for tens of thousands of dollars per share.

    Such a high share price might scare off less experienced investors who assume that they “can’t afford” the stock. The converse can also be true. While a $2 stock is theoretically no better or worse than a $10 stock, investor perception may be much different with share prices at $10 per share rather than a share price of $2.

    Additionally, certain contractual arrangements or stock exchange listing requirements may necessitate a higher share price, although simply reverse splitting the stock may not be sufficient in these cases.

    Stock split calendars show investors when upcoming stock splits and reverse stock splits are scheduled to occur. Stock traders may then use that information may buying or selling decisions based upon how they believe the market at large might react to the changed pricing of the stock.