At first it might seem like some unexpected good news: you log in to check your stock portfolio and get a temporary thrill when it seems that one of your penny stocks has doubled in price overnight. Chances are, though, that you shouldn’t break out the champagne just yet. Very often, particularly in this market, a sudden surge in an equity’s price is because of what is known as a “reverse” (or forward) stock split.
TRADITIONAL STOCK SPLITS
The term “split” in relation to stocks is more commonly used as the name would suggest, when a stock’s dollar value is split by the issuing company, usually in half. Say a company such as Intel reaches 100 dollars per share (ah, those were the days…). In an attempt to manipulate investor sentiment, a company might think that it is better to split the cost of the share to 50 dollars so that investors think that there is still some value left in the price. In other words the thought is that investors might think that $100 might be too much to pay for a stock and that more investors might pay $50 a share even though there is no real difference.
During the run up in tech stocks in the 1990’s, stock splits were a regular occurrence. Often the price (even split-adjusted) would spike right afterward because the development was seen as not only a positive statement about the company’s performance, it was also an optimistic one in terms of future potential.
REVERSE SPLITS
These days, many of those same high fliers have been subject to “reverse” splits. So say a company like Iomega is trading at 1.00 per share (those ARE the days…). Iomega might decide that at this dangerously-low level there will be little investor interest in their company. Also there are certain trading restrictions that are triggered when share prices go below certain levels. Reverse splits don’t always stick with multiples of two. For example that same dollar stock could the next day after being reverse split be trading at 10 dollars. There would then be a tenth of the number of shares on the market.
CONSEQUENCES OF REVERSE SPLITS
Reverse splits, like regular splits, affect the number of shares of a stock outstanding. Say company X had 10,000 shares trading one day, after a regular split it would then have 20,000 shares on the market. So the reverse applies to reverse split. If a stock is adjusted from one to five dollars a share, the numbers of shares on the market would then be reduced by one fifth.
In addition to the fact that the benefits of reverse splits are not demonstrated, there are also a few risks of the manipulation. One major problem with the reverse split is that it often has the opposite effect than it was intended to have. Just like a stock split is seen as a sign of hope and optimism, a reverse split is seen as a sign of fear and pessimism. It often results in even further depression of the stock price from split-adjusted levels. And just like a split is seen to give value to inflated shares, a reverse split is often seen as making a share look “too expensive.”
SUMMARY
A reverse split is hoped to combat some of the consequences and negative investor psychology of depressed share prices. But anyone who braves the ups and downs of the stock market will need to prepare themselves for the possibility that the shares will fall to zero or near to it. Investing in individual stocks is not for the feint of heart. Reverse splits are perhaps designed to shield investors from what is only an inevitable reality in the cases of many ill-fated companies.