RV Blog What is a Reverse Stock Split?

What is a Reverse Stock Split?

What is a Reverse Stock Split?

A reverse stock split is a corporate action that consolidates the number of existing shares into fewer, more expensive shares. The company can reverse split the stock by any multiple, such as 1-to-2, 1-to-5, or 1-to-10. If the company has 100 shares and reverse splits the stock using a 1-to-5 ratio, it will be left with 20 shares outstanding (100 / 5 = 20). Meanwhile, the price per share will be multiplied by 5. If the company’s stock was trading at $50 per share before the reverse stock split, the price will increase to $250 per share. 

But a reverse stock split doesn’t affect the total value of all the company’s shares. Before the reverse stock split, the company had 100 shares, each worth $50, which comes out to $5,000 (100 x 50 = 5,000). After the reverse stock split, the company has 20 shares each worth $250, which totals $5,000 (20 x 250 = 5,000).

Also known as stock consolidation, stock merge, or share rollback, a reverse stock split is mainly used to increase the value per share by reducing the number of existing shares. While the company’s total market value remains unchanged, it is typically used as a last resort following a recent decline in stock prices. The move often comes with a negative connotation. It can signal to investors that the company’s stock prices will not recover based on the company’s performance alone. For this reason, reserve stock splits can be self-defeating. Stock prices will decline if investors decide to sell out of fear the company is struggling financially. 

Related: What is a Stock Split?

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Do You Lose Money on a Reverse Stock Split?

Shareholders do not lose money on a reverse stock split. The move consolidates the number of shares in existence, but the total value of the shares remains the same. An investor with 200 shares of a stock trading at $20 per share has a total of $4,000. If the company does a 1-to-2 stock split, the investor will only have 100 shares, each worth $40 with a total value of $4,000.

The reverse stock split doesn’t cause investors to lose money by itself, but the move can signal to investors that the company is in financial trouble, which can lead to a sell-off. This will lower the value of the stock price, and stockholders will lose money.

Who Benefits from a Reverse Stock Split?

Reverse stock splits aren’t all bad news. Some companies may have no choice but to consolidate shares and raise the price per share if the stock price declines rapidly. Stock must be traded at or above a certain dollar amount to stay on major trading indexes such as the S&P 500 or NASDAQ. Companies may need to boost the stock price to stay on the index artificially. For example, NASDAQ requires stocks to be traded at or above $1 per share. If the company’s stock drops below this price point for 30 consecutive days, it will receive a notice saying it has 180 days to comply. The company can do a reverse stock split to increase the trading price and avoid being delisted.

Raising the price per share via a reverse stock split can also make the stock more appealing to big investors, including mutual funds and exchange-traded funds (ETFs) that avoid buying stocks that trade below a certain dollar amount.

The executives of a company may also seek to reduce the number of shares outstanding if they plan on taking the company private. The move often reduces the total number of shareholders, making it easier for the remaining shareholders to retain control of the company.

The company may also need to reduce the number of shares or shareholders to comply with market and trading regulations. In other cases, executives may also reverse split their stock if they plan to sell shares in a new company or business venture. Increasing the stock price of the original company can help the new shares start at a higher price.

The Bottom Line

Reverse stock splits tend to have a bad reputation, but they can be used in ways that benefit companies. It reduces the number of shares outstanding while increasing the price per share without changing the company’s total market value. However, the move can lead to diminishing investor confidence or even a sell-off if the company seems to be in financial straits. Investors will only lose money during a reverse stock split if the stock price falls after getting a temporary boost.

RELATED CATEGORIES: Stock Market