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Thursday, April 28, 2011

Understanding Reverse Stock Split

Many companies attempt to list their securities on one of the major stock exchanges, like NSE, in order to provide greater liquidity to shareholders. In order to earn and maintain exchange listing, the corporation must meet several criteria, including a minimum number of round lot holders (shareholders owning more than 100 shares), total shareholders, net income, public shares outstanding and price per share.

In times of market or economic turmoil, individual businesses or entire sectors may suffer a catastrophic decline in the per share stock price. The aftermath of the real estate bubble is the perfect example; many stocks fell by 90 percent or more. If the market price falls far enough, the company risks being delisted from the exchange; a terrible tragedy for existing stockholders.

In order to avoid this, the Board of Directors may declare a reverse stock split. The move has no real economic consequences. Here’s an illustration: Assume you own 1,000 shares of XYZ Industries, each trading at Rs 15 per share. The business hits an unprecedented rough patch; it loses key customers, suffers a labor dispute with workers, and experiences an increase in raw commodity costs, eroding profits. The result is a dramatic shrinkage in the stock price – all the way down to Rs 0.70 per share.

Short-term prospects don’t look good. Management knows it has to do something to avoid delisting, so it asks the Board of Directors to declare a 10 for 1 reverse stock split. The Board agrees and the total number of shares outstanding is reduced by 90 percent. You wake up one day, log into your brokerage account, and now see that instead of owning 1,000 shares at Rs 0.70 each, you now own 100 shares at Rs 7.00 each. Economically, you are in the same position as you were prior to the reverse stock split, but the company has now bought itself time to get back on right track.