Reverse Split Death

Contrary to popular belief, there is no such thing as a true bottomed-out share price. It’s almost a funny concept that those who trade on the upper exchanges believe that a share price of $0.01 (one penny) is the lowest a stock can go. Any penny stock investor (PSI) knows this to be a myth when they start venturing into the subpenny stocks. Yet it’s also a common mistake for those on the lower exchanges to believe that $0.0001 (one hundredth of a penny) is the lowest a stock’s share price can go. This is simply not true.

The value $0.0001 holds significance in the eye of penny stock investors because it is the lowest digit place that most brokerages will allow to be traded. Nevertheless even this can not be viewed as a practical bottom. Enter the dangers of the reverse split. A reverse split is an easy enough concept to understand: For every x amount of stock you own, you are now given y amount of stock (where X>Y) as the share structure is equally cut by a specified ratio. For instance, if you had 1000 shares of ACME Inc. that underwent a 1:10 reverse split, you will end up with 100 shares of ACME Inc. even though the value of those shares have not effectively been changed.

However, the dangers of this shifty maneuver are not in the action itself. A split of any kind will never change the inherent value of that stock (for all intensive purposes - we can talk about protected preferred shares another time). The dangers of this maneuver (aside from the affected shareholder sentiment that reacts to the announcement of a reverse split) is in the likely subsequent action of the company. A company that feels like it needs to reverse split typically has the intention of further diluting the stock once again in order to raise capital. Going back to our example of ACME Inc., pretend that the share price was originally $0.10. After the effective 1:10 split, the share price now becomes worth $1.00. This is a more respectable share price to the psychology of the shareholder despite the fact that the value of the stock has not inherently changed.

It is rare for a company to decide to reverse split its stock without having the intention of later diluting it. One possible reason in which this might take place is when a company needs to hit a certain price to retain its listing on a certain exchange. Another reason is that a company might merely want a more respectable share structure (a few million shares instead of a few hundred million shares). Yet for the most part, reverse splits are never as innocent as these scenarios. Often, these might even be used as the masking reasons behind the true intentions of the company.

Reverse splits are common on the lower exchanges. Many companies end up diluting there stock so much that the original price of the company’s stock may appear to have been worth hundreds if not thousands of dollars at one point in time. Typically, it’s a good idea to avoid companies that undertake reverse mergers entirely. Companies that are the product of a reverse merger (that might have included a reverse split) are a different story entirely. We will talk more about this another day.