Stock Splits and Reverse Stock Splits for the Beginning Investor

A stock split occurs when a publicly traded company’s board of directors votes to divide (split) the company’s outstanding shares into two or more shares. The total value of the stock held by any one shareholder does not change. In the case of a dividend stock, the total dividend paid to the shareholder will not change. It is very much like having a ten dollar bill and changing it into two five dollar bills. You still have ten bucks!

Why Would a Corporation Do That?

The most frequently cited reason for a publicly traded corporation’s board of directors invoking a stock split is to broaden the stock’s availability to the general public. When a stock’s share price is very high, it can be beyond the reach of many investors. One excellent example is Google Inc. (GOOG). Google trades at around $875 per share. I confess it is not in my portfolio!

Imagine that you are trying to achieve a diversified portfolio on a limited budget. You may have to pass on a company like Google because the high share price limits your ability to diversify.

If Google’s board invoked a ten-for-one stock split, you could own a share for around $87.50 (1/10th the current share price). Conversely, if you owned one share of Google and it split (ten-for-one), you would suddenly own ten shares. The total value of your holdings, however, would be unchanged. Potential investors often benefit from stock splits. Frequently, a stock split is a signal the company is growing.

Google, by the way, has given no hint that it is entertaining the notion of a stock split. So, that brings us to the reverse stock split.

What Is a Reverse Stock Split?

Not surprisingly, it is the exact opposite of what we have just described. Let’s use Sirius XM Radio, Inc. (SIRI) for our example. Sirius XM trades at around $3.25 per share. If the Sirius board of directors declared a reverse stock split, say one-for-ten, you would need to surrender 10 shares of stock to receive one share valued at $32.50. Think of exchanging 10 dimes for a dollar bill—it is the same principle.

Okay … Why Would a Corporation Do That?

I know, it sounds counterintuitive. After all, I implied earlier that cheaper stock prices attract investors, but it isn’t that simple. You see, there can be good and bad reasons for a reverse stock split and as a beginning investor, you need to be able to recognize the difference.

Before I continue, let me assure you that I am unaware of any plan by Sirius XM Radio Inc. to declare a reverse stock split. This is just an example!

Good Reasons for a Reverse Split

Many mutual funds are prohibited by policy from acquiring the stock of a company that trades below a set minimum price. The theory behind this policy is that it precludes mutual funds from trading in smaller and riskier companies, so-called penny stock.

Unfortunately, many companies, such as Sirius XM Radio, have respectable earnings, growth potential and acceptable financials, but fund managers can’t touch the stock. As a result, a company’s board may opt for a reverse stock split to increase share price.

This allows the company’s stock to be considered on its merits by mutual fund managers. Shareholders stand to benefit because increased demand for a stock tends to push share prices higher. The company benefits by increasing the potential value of its stock.

Bad Reasons for a Reverse Stock Split

Occasionally, a company finds itself in a pickle. The stock price is tanking and, as a result, investors are selling off stock. This forces share prices even lower as supply outstrips demand.

In such a scenario, a less than scrupulous board of directors may invoke a reverse split to shore up the share price, hoping investors, not well-versed in the market, will fail to notice the deteriorating value of the company.

In extreme cases, share prices of a company may fall below the level mandated by the exchange(s) on which they trade.  A company facing this prospect will often initiate a reverse split to remain with the exchange. This buys the company time to recover and avoids the almost certain oblivion that would result from being forced off the exchange’s roles.

For these reasons, any company involved in a reverse split should be thoroughly vetted before any stock purchase is considered. This, of course, should be your policy with regard to any investment.

Do you have any thoughts on reverse stock splits? Have you had any personal experiences with stock splits that you could share?

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