The reverse stock split also known as the stock merger, is the consolidation of the existing number of shares of the company into the fewer stocks of the same company resulting in an increase in the per-share value of the outstanding shares.
Reverse Stock Split Definition
Reverse Stock Split is a company action that results in a reduction of the number of shares of a company currently outstanding in the market. For example, under stock split 1 for 2, an investor receives 1 stock for every 2 stocks that they hold thereby reducing the number of stocks held by the investor to half.
So if a person has 100 shares as on date, post stock split, they will own 50 shares. The market capitalization of the company remains the same thus not affecting the net value of shareholder value. The price of the shares is increased and adjusted such that market capitalization of the company remains unchanged post stock split in 1 for 2.
Examples of How Reverse Stock Split Works
Below-mentioned reverse stock split examples provide an outline of how it works and the reasons such corporate actions are taken by the companies.
Reverse Stock Split Example #1
Samantha, an investor, is currently holding 500 shares of XYZ limited at a value of $ 20 per share, thus total investment in the company’s share is of $ 10,000. XYZ Limited has a total of 10,000,000 shares outstanding in the market and the company planned on going for a stock split of 1 for 2. Thus every 2 shares owned by the shareholders will get converted into 1 share.
How will the stock split of 1 for 2 affect Samantha and XYZ limited?
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Effects on the company XYZ limited:
- Currently, XYZ Limited has 10,000,000 shares outstanding at a price of $20 per share. Thus, the total market capitalization of the company at present is $ 200 Million.
- With a stock split of 1 for 2, the number of outstanding stocks of the company will reduce to 5 Million (i.e 10,000,000/2)
- As was stated earlier, the market capitalization of the company remains unaffected by a reverse stock split. Hence, 5 Million shares currently outstanding must add up to achieve a total market capitalization of $ 200 Million. Hence the share price of the stock should increase, thereby changing the value of each share to $ 40 ($200 Million/5 Million shares outstanding).
Effect on capital held by Samantha:
- Samantha was earlier holding 500 shares. Post stock split, Samantha will have 250 shares in her kitty. Further as stated before, the value of each share will also be revised to $ 40 per share. Thus, the total investment value for Samantha will remain constant at $ 10,000.
- Though the investment value of Samantha remains constant in theory, practically investment value may increase or decrease basis market sentiment towards stock split action taken by the company.
Reverse Stock Split Example #2
A company ABC limited is trading on the stock exchange at a price of $ 10 per share with 500,000 shares outstanding. Thus market capitalization of the company would be $ 5,000,000. Due to some recent changes in the industry of operation of ABC Limited, the company faces liquidity concerns. The market for the products of the company also went down. All these events lead to a gradual decline in the stock price of ABC limited to $ 1.5 per share in a span of a year.
If the price of the share falls below $1 there is a risk that the stock exchanges with minimum price criteria may delist the stock. Considering the same, the company is concerned about the share price further going down which might lead to the delisting of the stock. Hence, as a precautionary measure, the company decides to go for a stock split 1 for 50.
Thus, the following changes will happen for the company post stock split:
- Number of shares outstanding in the market would be 10,000 shares
- Thus to maintain the market capitalization of the company, the share price for each share would be
Share price post stock split = Market cap/number of outstanding shares post stock split
= $ 5,000,000/10,000 = $ 500 per share
This will help the company XYZ limited in the following ways:
- It will improve the share price of the shares thus diverging the delisting fears from the company.
- If a share price has fallen dramatically and stock having single digit share price is viewed as risky stock. A stock having a value of less than $ 1 is called a penny stock. There is a stigma attached to a penny stock and hence not many investors invest in such stocks. Thus to prevent the company from falling into the penny stock category and thus avoiding the negative market sentiment, the company might opt for a stock split.
- Further, the higher share price would help the company get attention from market analysts. Analysts tend to pay more attention to higher-priced stocks in comparison to penny stocks. Thus more attention from market analysts tend to generate more investor interest in the stock.
Journal Entries for a Reverse Stock Split
There are no major journal entries that need to be passed by the company to perform a reverse stock split since the overall value of the capital of the company remains constant. However, there is just one entry passed in the memorandum of the company to indicate that the numbers of shares outstanding have decreased.
As stated above, there might be many motives behind a company going for the reverse stock split, each one having a different goal to achieve. In general, this kind of corporate action is perceived to be negative in the market. Having said that, whether a reverse stock split is a positive action or negative majorly depends on the type of the company and the situations under which such a decision is being taken. Thus, investors should analyze the business and current changes in the company and industry of its operation before investing in the shares of the company who has recently gone for a stock split 1 for 2.
This has been a guide to Reverse Stock Split and its definition. Here we also discuss how it works along with practical examples of the reverse stock split 1 for 2 and more. You can learn more about accounting from the following articles –