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Investors are bombarded with various terms between stock splits, reverse stock splits, split adjusted, and dividends.
To help you cut through the noise, we are going to help you understand reverse stock splits. Read on to find out what a reverse stock split is, how it works, and whether it’s a good thing or not.
What Is a Reverse Stock Split?
A reverse stock split is an action of consolidating a company’s existing shares into fewer outstanding shares.
Instead of creating more shares, the company seeks to reduce its outstanding shares for investors, ultimately increasing its price.
How Do Reverse Stock Splits Work?
Either way of splitting shares, reverse or direct, it does not change the company’s value. What it merely does is alter the number of shares available for investors to own.
This means that the company is simply adjusting the price of each stock to gain some benefit from it.
>> Next Steps: Learn How to Research Stocks
Reverse Stock Split Example
In this example, Company XYZ has 10,000 shares and decides to perform a reverse stock split.
Currently, the price of each XYZ stock is trading at $1, and the company seeks to perform a 1-to-10 reverse split.
What results from the reverse split is that the company now only offers 1000 shares for investors.
Since XYZ’s shares have been reduced by 10 times, the price would increase 10 times from $1 to $10 per share.
Why Would a Company Do a Reverse Stock Split?
Avoid Exchange Delisting
Most companies prefer maintaining their status as a listed company on exchange as it is an effective way to raise capital.
However, an exchange would consider delisting a company if the company’s stock price is too low for too long.
For example, Nasdaq starts a motion to delist a company if its stock price is below the buying price or market cap for 30 consecutive business days.
Stocks that become too cheap would be classified as a penny stock — below $5. Penny stocks are vulnerable to big swings in prices simply due to how cheap it is to swing 10% of its value — it takes only 10 cents to alter a $1 stock.
Penny stocks are also vulnerable to price manipulation and fraud, which big exchanges don’t want to be associated with.
Attract Institutional Investors
Institutional investors have policies that allow them only to trade companies of a certain valuation.
It would be favorable for a stock to gain the interest of institutional investors because they trade in large volumes compared to retail traders.
This facilitates liquidity and promotes interest in a stock, which contributes to the company’s reputation as a stock on the market.
The price of a stock is also vaguely tied to the financial health of a company. In this sense, a higher stock price makes a good first impression for analysts to look at.
In addition, a higher stock price is more likely to gain attention from the press. If the fundamentals of a business are strong and the company wants to gain attention for it, managing its stock price by a reverse stock split could be a viable option.
Lower the costs for investors
A broker may charge a commission based on the quantity of stock purchased.
For this reason, investors would prefer buying the stock of a company that is worth a bigger portion of a company than multiple, cheaper-priced stock for a smaller part of the company.
Having a stock price that is like its competitors helps to level the playing field in attracting investors to purchase its stock.
This is a form of marketing tactic we also see in retail stores, known as price matching. Price matching attempts to assure the customer that the price they see is the best they will get in the market, encouraging them to buy it.
You would correctly guess that a well-researched investor would not fall for such a trick, especially knowing that the company had performed a reverse stock split.
Is a Reverse Stock Split Good or Bad for Investors?
Although a reverse stock split does not change the company’s value, it is commonly perceived as a sign of weakness. Therefore, you should dig deeper into why a company has decided to do so.
One red flag might be having observed selling pressure throughout the time leading up to a reverse stock split.
This might suggest that the stock has been suffering due to cracks in the fundamental of the business. At this point, it is a clear indication for an investor to review their thesis for the stock.
How Do Stocks Perform After a Reverse Stock Split?
Because of the negative stigma and reasons linked to a reverse stock split, stocks tend to perform poorly in the short term after the company has announced its intentions and may continue indefinitely after that.
This does not necessarily mean that the stock is doomed to continue dropping in price; it still depends on the underlying business and what investors think it should be worth.
One famous example of a stock doing well after a reverse split is Citigroup which underwent a 1-for-10 reverse split in 2011.
It traded for $4 before the reverse split and climbed upwards from $40 post reverse split to $71.62 at writing.
Can You Make Money on a Reverse Stock Split?
There is no change to the company’s valuation no matter which way the stock splits.
Unfortunately, the stock is more likely to drop in value following such a piece of news because the reason associated with it is usually negative.
However, if there is positivity in the execution, the stock may recover and do well after a temporary bout of continued selling pressure, as we have seen with Citigroup. Other stocks that have done well after a reverse split are AIG and Motorolla.
Do You Lose Money on a Reverse Stock Split?
You do not lose money since altering the number of shares does not change the company’s value, which is derived by shares outstanding multiplied by the price per share.
You would lose money only if you realized the losses by selling the stock below your buy-in price.
It might be a good thing to sell early to cut losses if you think that the stock price is likely to continue underperforming from then on.
What Happens If I Own Shares of a Company Before a Reverse Stock Split?
You will automatically hold the reduced number of shares priced proportionately to its decrease.
So back to our example on XYZ company whose stock is worth $1 before the 1-to-10 reverse split, it would now be worth $10 per share, and you own 10 times less the number of shares.
Reverse Stock Splits vs. Stock Splits
Stocks splits are associated with more positive news than the reverse. If a reverse stock split is a sign that a company is trying to keep its stock price afloat, then a stock split is a way to reduce the price of its shares to make it more accessible for more investors.
The price effect after a stock split is also opposite of a reverse stock split — an increase in price due to confidence in the fundamentals of the business reflected in its stock price.
Bottom Line: What Is a Reverse Stock Split?
A reverse stock split is an action taken by a company to reduce the number of outstanding shares, hence increasing the price of each stock. This action does not change the valuation of the company.
While this action is usually associated with negative news, investors should look for the reason behind a reverse stock split.
The reason for it may benefit the stock price in the future, especially if paired with a change in its underlying business.