What is a Reverse Stock Split?
A reverse stock split is an action taken by the firm to reduce the outstanding shares by increasing the price per share. It is also known as a stock merge or reverse split. This split merged the larger number of shares to smaller and shares price increased from small amounts to large. Similarly, it does not affect the total value of the firm. Some examples are 2-for-3, 3-for-5 reverse stock split.
The opposite of it a stock split, a stock split is an action taken or technique used by a firm (company, corporate) to increase the number of shares outstanding by reducing the par value and market price of the stock. Even, the number of outstanding shares increases the cash value of the company does not increase, rather than remains the same as pre-split amounts because it does not affect the balance sheet amount of the company.
When a company’s share price falls substantially, the company may want to reduce the number of shares outstanding. Numbers of shares reduced by a reverse stock split. The reduction of the number of outstanding shares increases both the par value per share and the market price per share. This split also increases earning per share and dividend per share.
Suppose A company announced a 2-for-5 reverse stock split. And the company has 10,000 outstanding shares and a price per share of $100. It means that the existing number of outstanding shares of the company decreased to 10,000 * 2/5 = 4,000 shares and the price per share increased to $100 * 5/2 = $ 250 per share.
Effects of a reverse stock split
May we point out some it affects the company and shareholders are as follows;
- Reverse stock split decreases the number of outstanding shares by increasing the par value of those outstanding shares.
- It does not affect the value of the firm.
- Increases the value of one share in the market.
- Increases the earning per share (EPS).
- Similarly, increases the dividend per share (DPS).
Why the reverse split?
The company always tries to maximize its value of the stock. When a company’s share price falls substantially, may the company reduce the number of shares outstanding. When the company has a low number of shares outstanding the earning per share and the dividend per share increase. May we take it one cause to announce reverse split. It is not a compulsion of a company but when it has to take action in reverse split the company takes by analyzing the nature of the market outside the company.
As we know the reverse stock split has no economic value plus it does the effect (increase or decrease) the existing balance amount of the company. Let’s clarify it through an example;
To illustrate it let us consider total shareholder’s equity account of a firm:
(10,000 shares @ $ 100 each)
Additional paid-in capital
|Total Shareholder’s Equity||$ 50,00,000|
Now, let us assume that the firm announced 2-for-5 reverse stock splits, which results into decrease in the number of outstanding shares from 10,000 shares to 4,000 (i.e. 10,000 shares * 2/5) and increased in par value from $100 per share to $ 250 per share (i.e. $100 * 5/2). This keeps the value of common stock constant at $ 10,00,000 (i.e. 4000 * $ 250). Thus the shareholder’s equity account of the firm after 2-for-5 reverse stock splits appears as follows:
|Common Stock (4,000 shares @ $ 250 each)|
Additional paid-in capital
|Total shareholder’s equity||$ 50,00,000|