The term "reverse stock split" is used in the context of corporate restructuring to describe a procedure by which a company reduces the number of shares available in the market. The effect of a reverse stock split is that it raises the share price of the company's stock while lowering the number of shares available in the market, so it does not affect the company's market capitalization.
What is Reverse Stock Split?
The issuing corporation exchanges a larger number of shares for a smaller number of shares in a reverse stock split. As a result of the reverse split, the price of the remaining shares will rise. There can be numerous reasons for this, including:
- The stock had previously traded in the penny stock range, which is where many investors avoid trading.
- A reverse stock split is recommended by an underwriter for a company seeking to go public to move the stock price into a range where investors will be prepared to buy it.
- A company's shares have fallen below the minimum bid price on the market where they trade, and the company's shares have fallen below that price.
- Smaller shareholders with ownership of less than one share can be removed from the company.
Example of Reverse Stock Split
For instance, suppose an investor has 100 shares of stock, each of which is now trading at INR 10. These shares have a market value of INR 1000 (divided by 100 shares at INR 10 each). A 10-for-1 reverse stock split is implemented by the issuing business. This means that the investor exchanges his old 100-share certificate for a new 10-share certificate. Due to the reduced number of shares, the market price rises to INR 100, indicating that the investor's holdings are still worth INR 1000 (calculated as 10 shares at INR 100 each).
Advantages of Reverse Stock Split
Short selling is done for those stocks that are very liquid because it is easy to borrow such stocks and traders have confidence that in case of stock price rise they can square off the position due to good liquidity, but when the stock is not liquid, they will think 10 times before shorting the stock and thus in a way reversing the trend.
A reverse stock split is frequently done by firms whose stock price has gone too low for their comfort. For example, if a stock was INR 1 before the reverse stock split and the company does a reverse stock split in the ratio of 1 to 5, the new share price would be INR 5 after the operation is complete.
When a company wants to reduce its shareholder base, a reverse stock split is beneficial because a large scattered base of shareholders can cause delays in decision-making. After all, any scheme that begins requires shareholder approval because they are entitled to vote, and a large scattered base will result in a divided opinion, causing the delay.
Disadvantages of Reverse Stock Split
The most significant downside of a reverse stock split is that it diminishes share liquidity in the market, and because illiquid shares are rarely traded, proper price discovery of the stock price may be hampered.
When it comes to reverse stock splits, small shareholders are left with even fewer shares and occasionally receive cash since their shares are insufficient, resulting in stock accumulation by big players at the expense of small shareholders.
Reverse stock splits are seen unfavorably by the markets because they may indicate that the firm is doing so to boost its share price, which could result in a reduced valuation of the company following the reverse stock split.
It is pretty evident that reverse stock split has both advantages and disadvantages. It requires detailed research about stocks to make the most out of reverse stock splitting. While reverse stock split may prove out to be beneficial for some investors, the situation can be entirely different from others.
Happy Investing!
