Why Reverse Stock Splits Hurt Shareholders

by Lee Distad

Once primarily a tool of shady penny stocks, the reverse stock split has become a favorite of exchange-listed financial companies during the chaos of the past year.

A reverse split reduces the total float of common shares while maintaining the same total market cap, mashing the stock price of multiple shares into the price of one super-share.

Late last year, the UK’s Royal Bank of Scotland, one of the most tempest-tossed non-US banks severely weakened from exposure to the US mortgage market, fell below $1 a share at one point. This led to the decision to undertake a 1:20 reverse split.

Earlier this month, Arlington Asset Investment Corp. (formerly Friedman, Billings and Ramsay) also undertook a 1:20 reverse stock split.

In the case of the Royal Bank of Scotland, a 94-cent stock became an $18.85 stock. For Arlington Asset Investment Corp., a $0.66 stock became a $13.20 stock.

Reverse Splits Don’t Create Any Value

Reverse splits may not totally destroy shareholder value, but they certainly don’t create it either.

For a start, there’s zero value created for existing investors. If you bought 10,000 shares of RBS when they were worth 94-cents each, after the reverse split you then owned 500 shares worth $18.85. Up front at least, there is little difference, since the book value of your shares are $9,425 either way.

I would even argue that investors have lost value, since by having their volume of stock cut by 20, they’ve lost the potential for gains that can be made from small movements in share price multiplied by a large block of stock.

A Higher Price Doesn’t Mean Better Shape

Reverse splits only delay the inevitable: decline, delisting, and becoming destitute.

A company’s fundamentals have in no way improved, despite a share price that’s 20 times higher than it was pre-reverse-split.

If the company is still troubled, a reverse split just gives the share price a higher roof to plunge from. Today, RBS is trading at $15.51, which is equivalent to 77 cents pre-split. At $13.21, AI’s pre-reverse split is equal to 66-cents, slightly up from the 50 cents it was trading at previously.

Of course, if as an uninformed investor you jumped in to RBS after the split and bought 10,000 shares at $18, God help you. Then again, you could argue that worrying about reverse-splits is irrelevant, since buying beleaguered financial services companies is a more risky activity than value investors should be engaged in.

But that’s a whole other topic.

About the author: Lee Distad consults with CE integration firms on design, installation and project management processes and Best Practices, and offers provides professional copy writing services for websites, brochures, and marketing initiatives. Visit him at www.leedistad.com.

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