Reconciling Theory with Post-Reverse Split Return Patterns: Empirical Findings Based on Recent Events

Abstract

When theory and data conflict, Black argued that the safest course is to assume the theory is correct. As splits do not alter cash flows, one such conflict is findings of negative abnormal long-horizon returns following reverse splits. The extant literature has concluded reverse splits destroy shareholder value. We reconcile the data with the theory by finding no evidence that a portfolio of common stock reverse splits over the 2002 through 2006 period experienced negative abnormal returns. While the price of a stock declines anomalously over the ten days following a reverse split, we propose to explain this via market microstructure. We model the stock of an ex-split firm as a call option on the firm’s assets, and assume a stock priced below $3.00 and above $4.99 is out-of-the-money and in-the-money, respectively. We find the frequency of deletions from the CRSP database due to poor performance is inversely related to option moneyness, with firms priced below $3.00 on the ex-split date exhibiting severe financial distress. Multiple reverse splits occurring within a 5-year window are analyzed separately and modeled as deep out-of-the-money options. We propose an alternative set of risk factors that include option time to maturity, moneyness, and implied volatility, and validate our findings out of sample. Our results are consistent with market efficiency.

Keywords: event study, reverse stock split, call options, market efficiency, market microstructure, abnormal returns and financial distress

JEL Classification: G14, G34