What Is a Reverse Stock Split?
A reverse stock split is a measure taken by companies to reduce their number of outstanding shares in the market. Existing shares are consolidated into fewer, proportionally more valuable, shares, resulting in a boost to the company’s stock price.
- A company performs a reverse stock split to boost its stock price by decreasing the number of shares outstanding.
- A reverse stock split has no inherent effect on the company's value, with market capitalization remaining the same after it’s executed.
- This path is usually pursued to prevent a stock from being delisted or to improve a company's image and visibility.
How a Reverse Stock Split Works
For example, in a one-for-ten (1:10) reverse split, shareholders receive one share of the company's new stock for every 10 shares that they owned. In other words, a shareholder who held 1,000 shares would end up with 100 shares after the reverse stock split was complete.
A reverse stock split has no inherent effect on the company's value, with its total market capitalization staying the same after it’s executed. Yes, the company has fewer outstanding shares, but the share price increases in direct proportion to the reverse stock split.
The total value of the shares an investor holds also remains unchanged. If an investor owns 1,000 shares each worth $1 before a one-for-10 reverse stock split, the investor would end up holding 100 shares worth $10 each after the split. The total value of the investor's shares, therefore, would remain at $1,000.
For companies that pay cash dividends, future dividends would simply be adjusted to reflect the new, lower number of shares outstanding; so, if a company paid its shareholders a $1.00-per-share dividend and it undergoes a 1:5 reverse split, the dividend becomes $5.00 per share, or five times the old payout. Note that the overall sum of dividend payments should remain the same.
Reasons for a Reverse Stock Split
There are several reasons why a company may decide to execute a reverse stock split and reduce its number of outstanding shares in the market. Here are the main three motives:
- Prevent being delisted from an exchange: If a stock price falls below $1, it is at risk of being delisted from stock exchanges that have minimum share price rules. Being listed on a major exchange is important for attracting equity investors and, in some cases, the only way to prevent removal is to increase share prices by engaging in reverse stock splits.
- Boost the company's image if the stock price has dropped dramatically: If the stock is trading in the single digits, it is likely to be viewed as a risky investment, particularly if the price is near $1 or considered a penny stock by investors. There is a negative stigma attached to penny stocks traded only over the counter (OTC), and sometimes the quickest method to escape this association and protect a company’s brand image is to engineer a reverse stock split.
- Draw more attention from analysts and influential investors: Higher-priced stocks attract more attention from market analysts, and a favorable view from analysts is excellent marketing for the company. They are also more likely to pop up on the radars of big institutional investors and mutual funds, many of which have policies against taking positions in a stock whose price is below a minimum value.
Criticism of a Reverse Stock Split
Reverse stock splits aren’t without flaws. In many cases, companies keen to artificially boost their share price in this manner risk being spurned by investors.
Reverse stock splits can carry a negative connotation. As previously stated, a company is more likely to undergo a reverse stock split if its share price has fallen so low that it is in danger of being delisted. Consequently, investors might believe the company is struggling and view the reverse split as nothing more than an accounting gimmick.