What is a Reverse Stock Split?

If you’re a shareholder, you might come across a stock split or a reverse stock split that changes the price of your shares. While many people know about stock splits, reverse stock splits might be somewhat less well-known. This blog post breaks down what a reverse stock split is, how it works, why companies do it and what the pros and cons are. Dive in to get a handle on this financial maneuver and how it could affect your investments.

How Does a Reverse Stock Split Work?

When a company undergoes a reverse stock split in the investing world, it combines existing shares into fewer, higher-priced shares. The total quantity of shares changes at a specific ratio, like a 1-for-2 or 2-for-3 ratio. If you started out with 10 shares of a stock worth $10 per share, in a 1-for-2 reverse stock split, you own 5 shares worth $20 each. A reverse stock split is also referred to as stock consolidation, stock merge or share rollback and is the opposite of a stock split, which divides a share into multiple parts.

A reverse stock split doesn't impact a company's value, only the price of its stock. It doesn't affect the total value of an investor's holdings, only the number of shares and the price per share. 

Why Do Companies Perform Reverse Stock Splits?

Companies may conduct reverse stock splits for various reasons, but the primary motive is often to avoid being delisted from major stock exchanges like the New York Stock Exchange or Nasdaq. These exchanges have minimum bid prices for stocks to be listed, and if a stock falls below that threshold for an extended period, it risks being removed.

Reverse stock splits are generally viewed as a negative sign for a company, as they suggest that the share price has fallen so low that the company might try to boost it. The reverse split may also indicate that the company is experiencing financial difficulties or has poor growth prospects. 

However, in some situations reverse stock splits could be considered positive, such as when they are accompanied by other changes that improve the company's performance or strategy. Reverse stock splits may also make the stock more appealing to institutional investors who have minimum price requirements for their portfolios.

Example of a Reverse Stock Split

Company XYZ has 100 million shares available for trading, with each share priced at $0.50. This gives the company a total market capitalization of $50 million. To increase its share price and prevent being delisted from Nasdaq, the company decided to perform a 1-for-10 reverse stock split. 

After the split, there will be 10 million shares available for trading, with each share priced at $5. This move will still give the company a market capitalization of $50 million. The number of shares held by each shareholder will be divided by 10, and the price per share will be multiplied by 10. For instance, if an investor had 1,000 shares before the split, they will have 100 shares after the split. However, the total value of their investment will remain unchanged at $500.

Advantages and Disadvantages of a Reverse Stock Split

A reverse stock split has benefits and drawbacks, which can affect companies and investors. 

Pros

• Prevent major exchange removal: The price of a stock may have dropped significantly, leaving it open to further market pressures and risks, such as failing to meet exchange listing requirements. Some exchanges require a minimum bid price for a stock to be listed. If the stock falls below this price and remains low for a certain period, it could be delisted from the exchange. For instance, Nasdaq has the authority to delist a stock that has been trading below $1 per share for a long time. To avoid this, companies can implement a reverse stock split to raise the share price enough to keep trading on the exchange.
• Improve investor perception: Investors, analysts and media may interpret a low share price as a weakness or poor performance indicator. To make the stock more appealing to potential investors who might avoid penny stocks or those with low liquidity, a reverse stock split could increase the share price. The reverse split could also enhance the company's reputation and image in the market.
• Reduce administrative costs: If a company undergoes a reverse stock split, it can lower the administrative expenses that come with having a high number of outstanding shares. This includes costs for printing, mailing and accounting. 
• Change the number of shares: A company may be subject to different regulatory requirements depending on its shareholder count. Reducing the share count can in some cases affect the type of regulatory scrutiny. 

Cons

• Signal financial distress: When a company is struggling to maintain its share price or market value, a reverse stock split is sometimes considered as a last resort. This may suggest that the company has not been able to improve its fundamentals or growth prospects and is forced to use superficial changes to boost its share price. Additionally, a reverse stock split could signal that the company is at risk of bankruptcy or liquidation.
• Reduce investor confidence: If a company decides to conduct a reverse stock split, it may cause a decline in investor confidence regarding its future performance and potential. This is because it could imply that the company has exhausted all other options to increase its value or attract new investors. Current stockholders may feel betrayed by this decision, leading to negative reactions. Some investors may decide to sell their positions or take profits at higher prices, resulting in renewed selling pressure.
• Increase volatility: If a company decides to do a reverse stock split, it might result in more unstable share prices because of reduced trading volume and liquidity. Short sellers or other market participants may manipulate or speculate the share price more easily since there are fewer shares available. This type of split could also cause confusion among investors who are unaware of the change in the number of shares or the adjusted price.

Stock Split vs. Reverse Stock Split

A stock split is a corporate undertaking that divides each existing share of stock into multiple parts, increasing the number of shares and decreasing the price per share proportionally. It is the opposite of a reverse stock split, which decreases the number of shares and increases the price per share. A stock split doesn't affect the company's value or an investor's total holdings, only the number and price per share. 

For example, if an investor owns 100 shares of a company valued at $20 per share, their investment is worth $2,000. If the company performs a 2-for-1 stock split, each share is split into two shares, and the investor now owns 200 shares valued at $10 per share, still worth $2,000 total.

A stock split is viewed positively for a company that is growing and performing well, while a reverse stock split is seen as a negative sign for a company that is struggling and underperforming.

Reverse Stock Splits: Smart Move or a Sign of Trouble?

A reverse stock split is a financial strategy employed by companies for various reasons, such as increasing the stock price, maintaining exchange listing requirements and attracting institutional investors. While it can provide short-term benefits, a reverse stock split can also signal financial distress and may not improve the long-term prospects of the company. If a stock you own undergoes a reverse split, try to find out the underlying reason for it.

Frequently Asked Questions