What is a reverse stock split? Why might a company undergo such a split?
Eligibility in many indexes such as the S&P/TSE Composite index requires that a company’s stock price be above a certain level. Mutual funds often use the constituents of a particular index as the pool from which they select investments. A stock, which drops out of the index, therefore, drops out of sight of such institutional investors. As well, some pension funds and mutual funds adhere to guidelines that do not permit them to invest in stocks that trade below a certain floor level, perhaps $1, $5 or even $10. When company share prices dropped dramatically, they risk being dropped from indices and automatically overlooked by mutual funds.
A reverse stock split is an inexpensive method of boosting the share price. The company issues one new share for a certain number of old shares. Once the process is complete the share price is higher and the number of shares in issue is lower. Without taking any negative market sentiment into account, the market value, also known as market capitalization, remains theoretically the same. Take for example, a fictional company ZZX Technologies. Let’s say that in August 2000 it traded at $50.00 and had 30 million shares outstanding. The market value then was $15 billion. It currently trades at $1.20 and market value is $36 million. The effect of a reverse share split is shown below.| Date | Share price $ | Shares Outstanding | Market Value $ |
|---|---|---|---|
| August 22, 2000 | 50.00 | 30,000,000 | 1.5 billion (1,500,000,000) |
| July 2, 2002 | 1.20 | 30,000,000 | 36,000,000 |
| Reverse share split on the basis of 5 old for 1 new share, effective August 22, 2002 | |||
| August 23, 2002 | 6 | 6,000,000 | 36,000,000 |