Friday, May 13, 2011

Reverse Stock Splits

Our local paper, the News and Observer, interviewed me a couple of days ago about reverse stocks splits.  The article was about a proposed reverse split by Duke Energy (NYSE:DUK) that is going to occur before it consummates its stock purchase of Progress Energy (NYSE:PGN).  Duke is planning a 3 for 1 reverse split which will raise its stock price from around $19 to about $57.  

The motivations for reverse splits are usually to get the stock into some sort of optimal trading range of $50 - $100 which will result in a nominal increase in EPS.  Of course economically, the transaction has no real impact, as all we've done is change the shares outstanding.

The evidence on splits shows that in general firms that do reverse splits underperform in subsequent years.   For example, a 1997 paper in the Journal of Business by Desai and Jain shows that reverse splitters underperform by 34% on average over the three years following the split.  There are a couple of possible reasons for this.  One is that reverse splits are sometimes done as a last ditch effort to avoid a delisting from a stock exchange.   In this case, the firm is probably on a serious decline and this decline just continues.   I doubt that this is the case for Duke Energy.   Another explanation for the poor performance, is that firms that are expecting significant stock price appreciation are unlikely to do a reverse split because their price will increase anyhow.   Therefore, the firms that do end up doing reverse splits are the ones that are not overly optimistic about their future performance.