In the investing world, companies do not give up total control of their stock shares after the initial offering. If they have no better use for free cash, they can buy back shares. This lowers the number of shares on the market (the "float") and tends to raise the earnings per share. Another strategy is the reverse stock split, in which shareholders see the number of shares they hold drop -- sometimes drastically -- with a concurrent rise in the stock price.
Companies announce stock splits as a ratio of two numbers. Thus, in a 2:1 split, shareholders get two new shares for every share they hold. This doubles the float and halves the stock price. The idea behind a stock split is to get the price down to where small investors find the shares a bit more affordable. Generally, public companies always want to increase the number of shareholders to get a larger percentage of the public supporting the company's success.
A reverse split turns the ordinary stock split on its head. In a reverse-split ratio, the second number is larger than the first. In a 1:50 split, shareholders get one share for every 50 old shares. The ordinary stock split and the reverse split take effect automatically and are calculated for shareholders by their account managers. After a 1:50 split, for example, a stockholder with 500 shares, will open his account screen to find that he now holds 10. Companies do not require shareholder approval for stock splits, nor is this maneuver under any kind of regulatory control by the federal government.
The stock market works through a complex network of computer systems that remain under human management. These systems allow stock prices to be manually adjusted when companies announce stock splits. That's why when a 2:1 split comes along, the stock price falls by half. When a 1:50 split happens, the market systems adjust the stock price upward by a factor of 50. While the company valuation remains the same, the number of outstanding shares is reduced. Shareholders who end up with less than a share after a reverse split may be automatically cashed out of their holding by their broker.
The purpose of a reverse split is simply to get the stock price up. For various reasons, companies don't want to see their stock price fall below important benchmarks. Large institutional investors, such as mutual funds, often have restrictions against buying low-priced stocks. The exchanges also have standards. If a company's average closing price stays below $1 for more than 30 trading days in a row, the New York Stock Exchange sets a six-month "cure period," after which it will de-list the stock if it doesn't get back above a buck. Although the aggregate value of the shares remains the same, a higher stock price will avoid the stigma of the "penny stock" and make an extremely inexpensive stock look a little more appealing to the general investor.
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