What is a Reverse Stock Split?
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A reverse stock split is a kind of corporate action in which existing stock shares are combined together to form fewer more proportionally valuable shares. Reverse stock splits reduce the total number of outstanding shares and raise the value of each individual share. They are the opposite of stock splits.
All publicly-traded companies have a set number of shares held by investors. Individuals and organizations buy and sell these shares on the market.
Depending on the company’s health and the broader financial landscape, corporate actors may elect to change the capital structure of their organization. Stock splits and reverse stock splits are two kinds of said actions.
Reverse Stock Split
In a reverse stock split, the total number of outstanding shares is merged to form a lesser number of more proportionally valuable shares. By decreasing the total amount of shares, reverse stock splits increase the value of each individual share.
The total dollar amount of shares remains the same because no real value was added. Reverse stock splits are also sometimes called stock consolidations, stock mergers, or share rollbacks.
In reverse stock splits, the total share number is divided by some number to get the new total share volume. Most of the time, this number is 5 or 10. In a 5-to-1 reverse stock split, each group of 5 shares would be consolidated into a single more proportionally valuable share.
Say an investor has 1,000 shares valued at 5$ each for a total of $5,000. If the company does a 5-to-1 reverse stock split, that investor would now have 200 shares valued at $25 each.
If the company did a 10-to-1 reverse stock split, then that investor would have 100 shares priced at $50 each. In each case, the total value of the shares remains the same, but the raw number of shares decreases. Either way, there is still only $5,000 worth of shares.
Generally, in cases when a person does not own enough shares to consolidate them into a single share, they will receive a cash payout. So if a person only has 5 shares and the company does a 10-to-1 reverse split, they will just be paid out the value of those 5 stocks.
Difference From a Stock Split
A reverse stock split is the polar opposite of a stock split. In a stock split, the total number of outstanding shares increases so there are more proportionally less valuable shares. Stock splits increase the total number of shares in circulation but the total dollar value of shares remains the same as each individual share is worth proportionally less.
The most common kinds of stock splits are a 2-to-1 and a 3-1 stock split. In a 2-1 split, the total number of shares doubles while the value of each share decreases by half. In a 3-1 stock split, the total number of stock triples but the individual share value decreases by a third.
Say a company currently has 20 million outstanding shares valued at $2 each. The company then performs a 2-to-1 stock split.
There would then be 40 million outstanding shares valued at 1$ each. The total number of shares increases but the value of each individual share decreases.
If you want a more “scientific” sounding description of how reverse stock splits and stock splits work, we can say that the value of each individual share is inversely proportional to the total number of outstanding shares. Given that the total stock value is kept constant, the more shares there are, the less valuable each share is. Consequently, the fewer shares there are, the more valuable each individual share is.
Why Would a Company Do a Reverse Stock Split?
Reverse stock splits might sound strange at first. Most investors like the idea of stock splits as they are usually a signal that a company is growing. Most stock splits occur because the share price of an individual stock is too high, compared to competitor companies.
By creating more shares of less proportional value, shares become more liquid so more people can invest. In that sense, stock splits are usually taken as a positive and a sign of positive investor sentiment.
In contrast, reverse stock splits are usually taken as a negative sign. Reverse splits are most often performed when a company’s share price has decreased and they need to boost their image.
If a stock falls below $1 per share, it may get delisted from exchanges that have minimum share price rules. Companies might perform a reverse split to inflate share prices and avoid the negative connotation associated with low-value “penny stocks.’
Sometimes, companies will perform reverse splits concurrently with stock splits. Such reverse/forward stock splits are normally done to cash out investors who own less than a certain amount of shares. This practice is believed to cut administrative costs by reducing the number of shareholders that need administrative support.
So for instance, a company may perform a 100-to-1 reverse stock split to cash out investors that hold fewer than 100 shares. The company can then perform a 100-to-1 stock split which will return the original number of shares to investors that weren’t cashed out. The total number of shareholders is decreased as those who were cashed out initially do not get their shares back.
Lastly, companies may perform a reverse split to receive a different corporate classification. For example, a Subchapter C (normal) corporation might perform a reverse split to reduce the total number of shareholders and be granted Subchapter S classification, which is reserved for corporations with fewer than 100 shareholders. Subchapter S corporations have the benefits of incorporation but are taxed like partnerships, so it can be beneficial for companies to change classification sometimes.
Effects of a Reverse Split
In and of itself, a reverse split has no effect on a company’s total market capitalization. The total dollar value of the company’s shares remains exactly the same, the number of shares just decreases. In an ideally rational market, a reverse stock split would not have much effect.
However, the actual market is by no means rational and emotions often drive price changes and buying behavior. Stock splits have a generally negative connotation. These negative connotations or reverse stock splits have a compounding effect.
If a company performs a reverse split so that its shares do not get delisted, investors may take that as a sign that the share price has decreased because the company is in a bad state. The negative investor sentiment can build up and decrease buying behavior for that security. So even if there is actually nothing wrong with a company and it’s doing well, a reverse split can cause a spiraling chain of share-price decreases.
Alternatively, reverse stock splits can be a good signal for smaller companies that boosting stock price so it rises out of penny-stock territory. These kinds of reverse stock splits attract the attention of investors as it signals a company is growing enough to be traded on regular markets.
How Does a Reverse Stock Split Affect My Investments?
As with pretty much everything in the stock market, it depends on the context of the specific split and broader market forces.
A reverse stock split by itself will not affect your investments as the total share value you own would still be the same (assuming you aren’t cashed out during the split). However, the negative sentiment associated with reverse stock splits might cause share prices to drop a bit.
It is also important to take the size of the company into question. Large established companies might perform a reverse split to make their share prices on equal footing with competitors to attract new investors.
Some companies, such as E-Trade, have benefited greatly from stock splits as the new share prices made them more competitive among larger investors. It seems that most firms that perform reverse stock splits and manage to prosper are larger, more established businesses.
So if you own stock in a company that is performing a reverse split, don’t get too hasty and immediately sell. You need to contextualize the reverse split upon recent price movements and fundamental metrics.
If, for example, a smaller company you are invested in is performing a reverse split after a period of strong growth and profits, then it could be a good sign as that company is large enough to be traded on reputable exchanges.
Alternatively, if a smaller company is slightly struggling and announces a reverse stock split, that could signal bad news. In that case, our advice is to cut your losses. But if a larger, well-run firm you are invested in announces a reverse split, stick around and do some more research before making a decision.
Case Study: Priceline
Sometimes, a reverse split can give a company enough time to rebound and recover from a bad performing quarter. A commonly cited example of a successful reverse split was Priceline, a popular online travel agency. In late 2000 following the tech bubble burst, Priceline’s share price had decreased from over $100 a share to just over $1 a share.
Normally, such signs are the death knell of a company, but in 2003, Priceline performed a 1-to-6 reverse split that changed the share price to $22. Then-CEO Jeffery Boyd stated in a press release that the reverse split was meant to enhance investor interest by making their share prices more equal to those of competitor companies.
Priceline’s share price now hovers around $1,400 a share, representing an astounding 6,000% share growth since 2003. These gains were not all achieved quickly though.
Despite an initial 2-year spike in growth following the split, Priceline was hit hard by the 2008 recession. But the company’s resilience saw major growth in the past 7 years after they have muscled their way into the international travel industry.
The point of this case study is to show that reverse stock splits can sometimes be very beneficial, despite the negative connotations. Reverse stock splits can be a way for a company to hang on just long enough to make a big turn around, and investors that are patient and wait out the bad times can be heavily rewarded.
Can You Profit from a Reverse Split?
Yes, individual investors can profit from reverse splits by short-selling. Short selling is a form of speculation that is based on betting that the value of a specific security will decrease.
Short selling involves borrowing shares of stock one does not own from a stock broker and selling those shares at the current market price. The general idea is to rebuy these shares at a lower price and return the borrowed shares to the lender, thus generating a profit. Short sellers are betting that the price of a security will decrease so they can make more money when they buy it back and return them to the borrower.
Short-selling is one viable method to profit from a reverse stock split as someone could borrow and sell stock, wait for the share price to decrease, then rebuy the stock and return it to the lender while pocketing the profit.
Keep in mind that short-selling is an advanced investing technique that is extremely risky. If you make a misjudgment and share prices actually increase after you sell the borrowed shares, you could lose a lot of money.
It can be very difficult to correctly predict future price movement and find an optimal time to buy. If you do make the right call though, short selling can generate extremely high short-term returns.
A reverse stock split does not necessarily signal something bad, though it is generally associated with negative investor sentiment. If a company you are invested in announces an upcoming reverse split, then depending on the company, it could be a good or bad signal for your investments.
Some companies manage to pull off reverse splits and recover just fine while other companies falter. The key thing to remember is that a reverse stock split announcement must be analyzed in conjunction with fundamental metrics of a company.