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Question: What is a Reverse Stock Split?
Answer: Many companies attempt to list their securities on one of the major stock exchanges, like the NYSE, in order to provide greater liquidity to shareholders. In order to earn and maintain exchange listing, however, the corporation must meet several criteria, including a minimum number of round lot holders (shareholders owning more than 100 shares), total shareholders, net income, public shares outstanding, and price per share.
In times of market or economic turmoil, individual businesses or entire sectors may suffer a catastrophic decline in the per share stock price. The aftermath of the Internet bubble is the perfect example; many stocks fell by 90 percent or more. If the market price falls far enough, the company risks being delisted from the exchange; a terrible tragedy for existing stockholders. At the New York Stock Exchange, for example, this is triggered after an issue trades at below $1 per share for 30 consecutive days.

In order to avoid this fate, the Board of Directors may declare a reverse stock split. The move has no real economic consequences. Here’s an illustration: Assume you own 1,000 shares of Bubble Gum Industries, Inc., each trading at $15 per share. The business hits an unprecedented rough patch; it loses key customers, suffers a labor dispute with workers, and experiences an increase in raw commodity costs, eroding profits. The result is a dramatic shrinkage in the stock price – all the way down to $0.80 per share.

Short-term prospects don’t look good. Management knows it has to do something to avoid delisting, so it asks the Board of Directors to declare a 10 for 1 reverse stock split. The Board agrees and the total number of shares outstanding is reduced by 90 percent. You wake up one day, log into your brokerage account, and now see that instead of owning 1,000 shares at $0.80 each, you now own 100 shares at $8.00 each. Economically, you are in the same position as you were prior to the reverse stock split, but the company has now bought itself time.

If you've spent a lot of time hanging around your broker's office or reading financial publications, you may have heard of a phenomenon known as the summer doldrums.
What exactly are the summer doldrums? Simply put, traders, brokers, money managers, and investment analysts are human. On warm, sunny days, many would rather be heading to the Hamptons to catch up with friends, or laying by the pool sipping a lemonade. If they aren't in the office, that means they aren't as likely to buy and sell stocks (would you be thinking about Home Depot, Berkshire Hathaway, or Coca-Cola while grilling steaks and playing with the kids?).

The reduced volume results in greater volatility because the transactions that are completed are going to have a bigger impression on the price of the stock. If you wanted to sell 1,000 shares of a thinly traded bank stock in North Carolina, the order may not have a huge effect on the equity's price if the company trades an average of 100,000 shares each day. If, however, trading volume falls 30% in the summer to 70,000, your order is going to have a more powerful influence on the price of the stock by pressuring it to fall as you sell your holdings.

In Wall Street lore, the summer doldrums officially end after labor day in September, when hedge fund managers, mutual fund gurus, and stock pickers head back to work and are forced inside as their kids return to school.

Market capitalization is a term used on Wall Street that is extremely important. Although it is often heard on the nightly news and in financial textbooks, very few new investors know what market capitalization is or how it is calculated. It’s actually really easy and intuitive. After you read about the details of market cap, as it is often called for short, you’ll understand the concept and begin using it when putting together your own portfolio.
The Definition of Market Capitalization

Put simply, market capitalization is the amount of money it would cost if you were to buy every single share of stock a company had issued at the current market price. For instance, The Coca-Cola Company has 2,317,441,658 shares of stock outstanding and the stock closed at $49.60 per share. If you wanted to buy every single share of Coca-Cola stock in the world, it would cost you 2,317,441,658 shares x $49.60 = $114,945,106,236.80. That’s just shy of $115 billion. On Wall Street, people would refer to Coca-Cola’s market capitalization as $115 billion.
Why is market capitalization such an important concept? It allows investors to understand the relative size of one company versus another. AutoZone, a retailer of auto parts, trades at $150.31 per share. Yet, the company’s market capitalization is only $8 billion. Despite having a stock price 3x higher than Coke, AutoZone is actually only 6.9% the size of the soft drink giant! This is why I wrote How to Think About Share Price. In that article, you learned that it’s possible for a $300 stock to be cheaper than a $10 stock.

The Shortcomings of Market Capitalization

There are some shortcomings to using market capitalization as a guide to a company’s size. The biggest is that market capitalization does not factor into consideration a company’s debt. In other words, in addition to having $115 billion in stock market value, Coca-Cola has $20 billion in debt. If you were to buy every share of Coke’s stock, you would own the company but still be responsible for the company’s $20 billion in debt. Thus, your “true” purchase price would be $115 billion + $20 billion = $135 billion. This figure is known as enterprise value and I explained everything you need to know about it in the article Enterprise Value – Determining the Takeover Value of a Company. There are actually some other factors that determine the difference between market capitalization and enterprise value so if you’re interested in the details, it would be worth your time to click over to those articles and take a few moments to read them.
Using Market Capitalization to Build a Portfolio

A lot professional investors divide their portfolio by market capitalization size. This approach, they believe, allows them to take advantage of the fact that smaller companies have historically grown faster but larger companies have more stability and pay fatter dividends.
Here is a breakdown of the type of market capitalization categories you are likely to see referenced when you begin investing:

Micro Cap: The term micro cap refers to a company with a market capitalization of less than $300 million.
Small Cap: The term small cap refers to a company with a market capitalization of $300 million to $2 billion.
Mid Cap: The term mid cap refers to a company with a market capitalization of $2 billion to $10 billion.
Large Cap: The term large cap refers to a company with a market capitalization of $10 billion to $50 billion.
Mega Cap: The term mega cap refers to a company with a market capitalization of $50 billion or more.

In the Left Corner: Certificates of Deposit

In the Right Corner: Money Market Funds

The Verdict

Although both can be useful, for those who need access to their capital and / or have much higher cash balances, money markets are often the superior choice.  For those who want to time maturities to certain events or benefit from a willingness to lock away savings for a long period of time, certificates of deposit are often the better portfolio selection.

In You’re Spending Your Millions $1 at a Time, you learned that compound interest has the power to turn seemingly small amounts into large fortunes if given enough time and the right rate of return. This article discusses the so-called Rule of 72. This rule allows the investor to quickly and efficiently answer two questions:

How long will it take me to double my money if I earn X%?
What return must I earn if I wish to double my money in X years?
Using the Rule of 72 When the Rate of Return Is Known

An investor that knows he can earn 12% on his money may ask the question, “How long will it take to double my money at this rate of return?”.

Using our handy Rule of 72, this is a snap to calculate! Simply divide the magic number (72) by the investor’s rate of return (12). The answer (6) is the number of years it would take to double the investment.

Using the Rule of 72 When the Number of Years Is Unknown

The Rule of 72 can also be used in reverse. An investor who wanted to double his money in a certain number of years could use the rule to discover the rate of return he would have to earn to achieve his goal.

Imagine, for a moment, a businessman who wanted to double his money in four years.  To estimate a rough rate of return required to achieve such a feat, he'd divide 72 by 4. The result (18%) is the after-tax compound annual rate of return he would have to earn to meet his goal on time.

Practical Examples of the Rule of 72 in Action

Q: John Q. Investor needs to double his money in seven years to reach his financial goals. What rate of return must he earn to do this successfully?

A: John would take 72 divided by 7.  The answer, 10.2857%, is the amount he will need to earn on an after-tax basis to successfully reach his goal.

Q: Susan Q. Investor is earning a 9% after-tax return on her investments. How long will it take her to double her money?

A: To calculate the number of years necessary to double her money using the Rule of 72, Susan would divide 72 by 9.  The answer, 8, is the number of years it will take for her investment to double after taxes.

• 76.3% wages
• 0.4% interest or dividends
• 4.8% Business, farm, self-employment income
• 0.1% capital gains
• 15.9% Social Security or retirement plans
• 2.5% transfers of societal benefits

• 55.8%% wages
• 8.7% interest or dividends
• 23.9% Business, farm, self-employment income
• 2.3% capital gains
• 7.8% Social Security or retirement plans
• 1.5% transfers of societal benefits

• No high school diploma = $23,000 per annum
• High school diploma = $36,600 per annum
• Some college = $42,900 per annum
• College degree=  $73,800 per annum

When it comes to investing, there are three ways you can make money from owning a share of common stock.

The initial dividend yield you collect
The growth in intrinsic value per share, which will fund dividend increases and capital gains
The change in valuation applied to the firm's earnings (i.e., how much every $1 in profit is valued)
When it comes to owning a bond, there are also three ways you might be able to make money.

The interest income you receive on the money you loaned the bond issuer.
The capital gains generated by buying a bond prior to a drop in interest rates or following an increase in the credit quality of the bond itself.
Special operations from unique circumstances, like conversion privileges being attached to a bond allowing you to swap it for common stock under certain scenarios.
When making a new commitment with your hard-earned money, it's often best to identify, clearly and specifically, how you think you are going to make your profit.  This one disciplined practice can help you avoid major bubbles as others get washed away by over enthusiasm, paying too much for their holdings.

Renoir once said, "Nothing is as disconcerting as simplicity."  He was correct.  Investors demonstrate this every day by behaving irrationally when it comes to managing their portfolios.  They try to be clever or outsmart their neighbor when what they should be doing is focusing on buying high quality assets, structuring their acquisitions in a tax-efficient manner, and growing richer with each passing year.

Let's take a moment to look at investing in stocks to illustrate how simple the process is.  The future value of stock must equal the sum of three components:

The initial dividend yield on cost
The growth in intrinsic value per share (for most firms, this amounts to the growth in earnings per share on a fully diluted basis)
The change in the valuation applied to the firm's earnings or other assets, often measured by the price-to-earnings ratio
That is it.  Those are the only three ways that someone who invests in stock can benefit economically.  He can collect cash dividends, he can share in the proportional growth of the underlying earnings per share, and he can receive more or less for every $1.00 in profit a company generates based upon the overall level of panic (fear) or optimism (greed) in economy, which in turn drives the valuation multiple.

For some companies, such as AT&T, the first component (dividend yield) is substantial.  For others, such as Microsoft for the first 20 years, it isn't because all of the return comes from the second component (growth in intrinsic value per fully diluted share) as the software giant grew to tens of billions of dollars in profit annually.  At all times, the third component, the valuation multiple, is fluctuating but has averaged at 14.5x earnings for the past 200 or so years in the United States.  That is, the market has historically been willing to pay $14.50 for every $1.00 in net profit a firm generates.

Using These Three Guidelines to Project Future Returns on Your Stock Market Investments

Imagine you want to invest in a lemonade stand that has only one (1) share of stock outstanding.  The lemonade stand owner offers to sell you this share of stock.  Your initial dividend is 4%.  The business grows at 10% annually.  You hold the share for 25 years and expand the company before selling it.

The historical price to earnings ratio for the stock market is 14.10.  Today, the S&P 500 is valued at a p/e of 14.07.

At today's prices, I think there is considerable evidence that an investor buying and holding a low-cost index fund such as the S&P 500 for the next 25+ years and reinvesting all dividends has a good probability of earning the historical real (inflation-adjusted) rate of return on capital of 7% compounded annually.  In terms of purchasing power, that would turn every $10,000 invested into $54,274 before taxes, which might not be owed if you held your securities through a tax-advantaged account such as a Roth 401(k) or Roth IRA.

Over the next 50 years, the same $10,000 investment could grow into $294,570 in real, inflation-adjusted terms.  That is a 30 year old man or woman parking money until he or she is Warren Buffett's age.

Stated another way, if you are a 30 year old investor and you put $100,000 in an S&P 500 index fund through a tax-advantaged account, you have a very good shot at having purchasing power equal to $3,000,000 by the time you are Warren Buffett's age without ever saving another penny.

This Is the Rational Approach You Should Use to Investing Your Money

Looking at your stock investments rationally is the only intelligent way to manage your wealth.  Whenever you are considering acquiring ownership in a business - which is what you are doing when you buy a share of stock in a company - you should take out a piece of paper or index card and write down all three components, along with your projections for them.

For example, if you are thinking about buying shares of stock in Company ABC, you should say something along the lines of, "My initial dividend yield on cost is 3.5%, I project future growth in earnings per share of 7% per annum, and I think the valuation multiple of 25x earnings that the stock currently enjoys will remain in place."

Seeing it on paper, if you were experienced, you'd realize that there is a flaw. A 25x multiple for a stock growing at 7% per annum in today's world is too rich*.  The stock is overvalued.  Either the growth rate needs to be higher, or the valuation multiple needs to contract.  By facing your assumptions head-on, and justifying them at the outset, you can better guard against unwarranted optimism that so often results in stock market losses for the new investor.

Sometimes, you can make more money by buying the least attractive stock in a particular industry if you believe the sector is due for a turnaround. Although it is counterintuitive, a little bit of simple math can show why it makes perfect sense and can leave the shrewd analyst with a much fatter pocketbook. These types of operations are for investors that have already built their complete portfolio and are on financially sound footing; they should not represent a substantial portion of your assets and are best left to those who have a good grasp of theeconomics and risks of the situation.

An Example in the Oil Industry

Imagine it is the late 1990’s and crude oil is $10 per barrel. You have some spare capital with which you wish to speculate. It is your belief that oil will soon skyrocket to $30 per barrel and you’d like to find a way to take advantage of your hunch. Ordinarily, as a long-term investor you would look for the company with the best economics and stick your capital in the shares, parking them for decades as you collected and reinvested the dividends. However, you remember a technique taught in Security Analysisand actually seek out the least profitable oil companies and begin buying up shares.

• Company A is a great business. Crude is currently $10 per barrel, and its exploration and other costs are $6 per barrel, leaving a $4 per barrel profit.
• Company B is a terrible business in comparison. It has exploration and other expenses of $9 per barrel, leaving only $1 per barrel in profit at the current crude price of $10 per barrel.

• Company A makes $24 per barrel in profit. ($30 per barrel crude price - $6 in expenses = $24 profit).
• Company B makes $21 per barrel in profit ($30 per barrel crude price - $9 in expenses = $21).

More Information

Typically, these operations are most successful in industries that are dependent upon underlying commodity prices for their profitability such as copper producers, gold mines, oil companies, etc. The wild fluctuations in the underlying commodity can result in huge swings in the earnings of the business, making them good candidates. Of course, unless you are a professional, you should not engage in these types of transactions, instead focusing onbuilding long-term wealth through value based, intelligent, and discipline investments that focus on getting the most earnings at the least risk.

Did you know that if you have at least a few thousand dollars in your brokerage account that you might qualify to borrow money against your existing stocks to buy even more? This practice is known as trading on margin. It allows people who want to get really aggressive to buy more shares of a company than they could otherwise afford.

The definition of margin

Margin maintenance requirements

The power of leverage - a practical example of margin in action

Margin basics

• All securities in your account are held as collateral for a margin loan.
• The margin maintenance requirement varies from broker to broker, stock to stock and portfolio to portfolio.
• If you fail to meet a margin call by depositing additional assets, your broker may sell off some or all of your investments until the required equity relationship is restored.
• It is possible to lose more than you invest when using margin. You will be legally responsible for paying any outstanding debt you may have to your broker even if your portfolio is completely wiped out.
• The interest rate charged by your broker on margin balances is subject to immediate change.

In some extreme cases, margin caused serious economic troubles. During the Crash of 1929 proceeding the Great Depression, maintenance requirements were only 10% of the amount of the margin loan; brokerage firms, in other words, would loan $9 for every $1 an investor had deposited. If an investor wanted to purchase $10,000 worth of stock, he would only be required to deposit $1,000 upfront. This wasn't a problem until the market crashed, causing stock prices to fall. When brokers made their margin calls, they found that no one could repay them since most of their customers' wealth was in the stock market. Thus, the brokers sold the stock to pay back the margin loans. This created a cycle until eventually prices were battered down and the entire market demolished. It also resulted in the suspension of margin trading for many years.

More Information About Trading Stocks

To learn more, read our guide to trading stocks. It will explain some of the basics of stock trading, pitfalls, and much more.

Famed hockey player Wayne Gretzky summed up his secret to success when he said, “go where the puck will be, not where it is.” When analyzing a company or mutual fund, many investors would do well to heed the same advice. Instead, they suffer from what is known in the business as “performance chasing”. As soon as they see a hot asset class or sector, they pull their money out of their other investments and pour it into the new object of their affection. The result is much akin to someone chasing lighting – they go where it has struck and then wonder why they continue to compound at lower than average rates of return; a tragedy that is exasperated by frictional expenses.

• What makes me think the earnings of this company will be materially higher in the future than they are at the present time?
• What are the risks to my hypothesis of higher earnings? How likely is it that these theoretical riskswill become actual realities?
• What were the original causes of the company’s underperformance? If it was in any way linked to aggressive accounting, what makes you sure that the situation has been permanently resolved and integrity restored to the firm? If it was an industry specific problem, what makes you think that the economics going forward will be different? A temporary supply and demand situation? Lower input costs?
• Has this particular sector, industry, or stock experienced a rapid increase in price in recent history? Knowing the principle that price is paramount, does this still make the investment attractive? Have the prospects for better earnings already been priced into the security?

Throughout hundreds of articles, lessons, resources, and tutorials, you’ve learned aboutfinancial statement analysis, discounted cash flows, accounting conventions, basic tax strategies, real estate, mutual funds, stocks, bonds, and more. All this knowledge is pointless, however, without the one key trait that has the power to save you from immense financial and psychological pain. That silver bullet is summed up in a single word: rationality.

Rationality Key 1: Know Thyself (Understand Your Own Psychology)

In each and every life decision there are ordinarily two distinctive choices: the one that makes the most sense in terms of financial or physical well-being, and the one that lets you sleep at night.

Rationality Key 2: Remember that Money is a Means, not an End unto Itself

Money exists solely to serve a purpose. All of the effort you put into selecting stocks and bonds is simply so you can have a better life for yourself and your family. There are other factors at work that supercede the time value of money. There is nothing wrong with a 25-year-old spending $400 on a cashmere sweater as long as she is fully aware that the decision not to invest cost her approximately $37,220 by the time she retires. Is a single item of luxury apparel worth such a hefty price tag? Only she can decide – but rationality dictates that the decision must be done with eyes wide open and even then, only if the decision won’t be second-guessed and regretted.

Rationality Key 3: Be Realistic

The ability to confront cold, hard reality is perhaps one of the most valuable traits an investor can possess. Figure out what you want, what you need to do to get there, and then develop a system that will take you to your goal. A case in point: A very close friend of mine is in her mid-sixties. She has consistently made poor financial decisions yet lamented that she is unable to own a home, even now. What’s worse, she resents those who are financially well off, despite the fact that many of those people worked their entire lives to save, invest, and build a nest egg.

Rationality Key 4: Don’t Be Moved By Emotion

As you were reminded in Stick to the Basics: Simple Reminders for Profitable Investing, movements in the quoted price of your investments are meaningless except in that they allow you to add to your holdings at attractive, lower valuations and sell your holdings at rich, higher valuations. As Graham said in The Intelligent Investor, to allow yourself to become perplexed by these movements is to become emotionally tormented by mistakes in other peoples’ judgment!

Rationality Key 5: Bolster Your Knowledge with Authoritative Sources

It’s much easier to remain impartial and unemotional when you are convinced you are correct and the market is wrong. Such self confidence can only be acquired by studying the basics of finance; check out Top 10 Investing Books for some recommended reads.

Conclusion

Financial decisions should be impartial, cold, and rational. Whether you are deciding betweenpaying off debt and investing, or analyzing an income statement, optimism and “irrational exuberance” should not be allowed to affect your decision making abilities. Think critically, logically, and do what makes the most sense for your bottom line within the confines of your personal psychology.

If you have more than a casual interest in building wealth and investments, you have no doubt come across the term risk adjusted rate of return. It's especially popular with the value investing crowd who tend to focus first, and primarily, on avoiding major losses and only then on generating gains. Although the concept itself is not particularly easy to define - there are no rules - focusing on risk-adjusted rate of return is an important protection that many investors would be wise to use when evaluating the various opportunities available to them, whether investing in a 401(k), 403(b), Simple IRA, SEP-IRA, Traditional IRA, Roth IRA, Roth 401(k), brokerage account, buying a car wash, or starting a new business.
The Concept of Risk Adjusted Rate of Return
The basic premise behind using risk adjusted rate of return is that you cannot look at the potential payoff of any investment and simply rank them from highest to lowest in terms of attractiveness. The reason is that it's possible to "juice" profits by doing incredibly stupid things, such as taking on risky ventures that aren't likely to succeed, or using substantial leverage such as borrowing large sums of money or trading in assets based on market movements as opposed to underlying intrinsic value.

In other words, if you had $10,000 to invest and Potential Investment AAA offered 10% per year, or $1,000 profit at the end of 12 months, and Potential Investment FFF offered 40% returns, or $4,000 profit at the end of 12 months, you would likely go for the latter at first glance. If you knew, however, that Investment AAA had only 2% chance of total loss and Investment FFF had a 60% chance of total loss, you would want to chance your analysis. On a risk adjusted rate of return basis it is clear that Investment FFF (which we should probably call "Speculation FFF" since it can hardly be called an investment) is not 4-times more attractive despite offering a rate of return 4-times as high.

In fact, given the basic rules of probability, Investment FFF is not even an intelligent gamble (to find out if it were, you take the potential gain, in this case $4,000, and multiply it by the odds of the bet coming out in your favor, or .40 resulting in $1,600. That is, the theoretical most you should be willing to risk for such a risk adjusted rate of return would be $1,600 not the full $10,000. If you come out ahead, it's pure, dumb luck - you weren't smart.)

Risk Adjusted Rate of Return Differs from Person to Person
How much you adjust absolute compound annual rates of return (or CAGR) for a risk adjusted rate of return depends entirely upon your financial resources, risk tolerance, willingness to hold a position long enough for the market to recover in the event you made a mistake, your tax situation, and your opportunity cost, among other factors. For instance, if you were looking at a 5.5% tax-free interest rate on a municipal bond and a 12% rate on a short-term stock trade but you found yourself in the 35% bracket for a net 7.8% rate of return, you may decide that the incremental 2.3% gain is not worth the additional risk of investing in stocks versus relatively short and medium-term bonds. The same investments for someone in a 0% or 15% tax bracket, however, change the inputs so the stock may offer a better risk adjusted rate of return because they are being compensated at a higher level.

More Information on Risk Adjusted Rate of Return
For more information on the concept, you should read our specials on opportunity cost and on the five-components of an investor's rate of return. You should also read CAGR - Compound Annual Growth Rate to learn how to calculate the absolute rate of return on any of your investments.

Arbitrage (sometimes called “risk arbitrage” or “merger arbitrage”) is a special type of investment operation that is meant to generate profit with little or no risk. By taking advantage of special situations that arise in the security markets from time to time, an investor can exploit price discrepancies created by special situations, increasing his net worth regardless of whether the market itself advances. This article discusses two of the more common arbitrage operations - those arising from mergers and liquidations – as well as the formula necessary to value the potential return on capital employed.

Corporate Mergers and Acquisitions

When a publicly traded company is acquired, the acquiring entity makes a tender offer to the current shareholders inviting them to sell their stock at a price usually above the quoted price on theexchanges or over-the-counter market. As soon as the tender offer is announced, arbitragers will rush in and purchase the security on the open market then turn around and sell it directly to the acquiring company for the higher price.

A Fictional Example of Risk Arbitrage in Mergers and Acquisitions

Acme Industries, Inc. decides to acquire one hundred percent of Smith Enterprises. Smith’s stock trades on the over-the-counter market and is quoted at $15 per share. Acme’s management makes a tender offer in the amount of $25 per share. This means that for a few, brief moments, an arbitrager can buy shares of Smith Enterprises for $15 each on the open market, turn around and tender (i.e., sell) them to Acme for $25. Through this operation, the arbitrager has made a quick profit of $10 per share from the spread that existed between the market price and the tender price.

Graham’s Indicated Annual Return Formula for Risk Arbitrage

To calculate the value of a potential arbitrage commitment, Benjamin Graham, the father of value investing created the following formula, which he discussed in length in the 1951 edition of Security Analysis; its creation was heavily influenced by Meyer H. Weinstein’s classic 1931 book, Arbitrage in Securities (Harper Brothers).