What is a Reverse Stock Split? Meaning and Impact Explained
Stock splits are an important part of discussions between investors and companies about how to change stock prices. While most people know about regular stock splits, a reverse stock split may sound unfamiliar. However, it is equally important, especially in the Indian stock market. So, let's understand what is a reverse stock split is and why companies do it.
Topics Covered
- What Are Reverse Stock Splits?
- Why Do Companies Opt for Reverse Stock Splits?
- Impact on Investors
- Conclusion
What Are Reverse Stock Splits?
A reverse stock split occurs when a company tries to increase its share price while decreasing the number of outstanding shares. This does not change the overall value of the company or an investor's holdings, the number of shares one owns, or the value per share.
When a company executes a 1:5 reverse stock split, the five existing shares are consolidated into a single share. So, if you used to own 500 shares pre-split, after the split, you will own only 100 shares at the same value because their price will adjust accordingly.
Why Do Companies Opt for Reverse Stock Splits?
- Compliance with Stock Exchanges: Companies listed on Indian stock exchanges, such as the NSE or BSE, must maintain a minimum share price. Share depreciation may cause the company to fail to fulfill the listing requirements. A reverse stock split inflates the value of a company's share without impacting its market capitalization.
- Improvement in Market Perception: Shares trading at very low prices are considered "penny stocks" and thus unlikely to attract Institutional investors. A higher price post-reverse split makes the share look more legitimate and attracts investors.
- Facilitate Mergers or Acquisitions: Companies going through mergers or acquisitions before reverse stock splits are quite common to create a favorable share structure or valuation.
- Reduce Volatility: Penny stocks are very volatile. A higher price after a reverse stock split would stabilize the stock's movement.
Impact on Investors
Indian investors do have a reason to feel anxious about a reverse stock split because such an event is usually associated with financially stressed companies battling low share prices. However, one should remember that a reverse split does not change the value of their investment.
Let's take an example:
Suppose you have ₹5.00 as the price of 1,000 company shares. If the company carries a reverse split of 1:10, you will now hold 100 shares valued at ₹50 each. The total worth of your holdings, ₹5,000, remains the same.
However, this is not the only aspect that can change post-split trading dynamics. Improved liquidity due to higher stock prices and, in some cases, renewed interest in the stock are possible scenarios. On the other hand, if a reverse stock split is perceived as a desperate move, it may discourage investors.
Conclusion
A reverse stock split is one of those strategic tools in the hands of companies to manipulate their stock prices and enhance perception in the market. It does not change anything because it doesn't change any value, but it signals that management is trying to correct some issues.