A company performs a reverse stock split to boost its stock price by decreasing the number of shares outstanding, which typically leads to an increase in the price per share.
How a Reverse Split Works
When a company does a reverse split, it cancels its current outstanding stock and distributes new shares to its shareholders in proportion to how many shares they owned before the reverse split. For example, in a one-for-10 reverse split, shareholders would receive 1 share of the company's new stock for every 10 shares that they owned. If a shareholder owned 1,000 shares before the split, the shareholder would own 100 shares after the reverse stock split.
Why Would A Company Perform A Reverse Split
A reverse split would most likely be performed to prevent a company's stock from being delisted from an exchange. If a stock price falls below $1, the stock is at risk of being delisted from stock exchanges that have minimum share price rules. Reverse stock splits can increase share prices to avoid delisting, and being listed on a major exchange is important for attracting equity investors.
A split might also be done to boost the company's image if the stock has fallen dramatically. If the stock is trading in the single digits, it'll likely be seen as a risky investment particularly if the price is near $1 or considered a penny stock by investors. A reverse split might be engineered by a company to protect it's brand's image by trying to prevent the penny stock label. There is a negative stigma typically attached to penny stocks traded only over the counter.
A reverse split sending the stock higher might draw more attention from analysts. Higher-priced stocks attract more attention from market analysts, and if analysts have a favorable view of a company and its stock, it's great marketing for the company.
The Effect of a Reverse Stock Split
A reverse stock split has no inherent effect on the company's value, so the company's total market capitalization is the same after the reverse split. 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 remains the same as well. If an investor owned 1,000 shares worth $1 each prior to a one-for-10 reverse stock split, after the split the investor would own 100 shares worth $10 each. The total value of the shares is still $1,000 for the investor.
Implications of a Reverse Split
Reverse stock splits can carry a negative connotation. As stated earlier, a company is more likely to undergo a reverse stock split because its share price has fallen so low that it's in danger of being delisted. As a result, investors might believe the company is struggling and that the reverse split is nothing more than an accounting gimmick.
However, a reverse split can be beneficial to a company by boosting its stock price to a level that enables it to transition from being a penny stock traded over the counter to being listed on a major exchange, thereby attracting the interest of more investors.