What Is a Reverse Stock Split?
You may have heard the term “stock split” on the financial news or in articles you read on the internet and wondered what all the fuss is about. In its simplest term, a regular stock split is when a company issues new shares to investors along with a corresponding slashing of its stock price. The net result is that the company maintains the same overall valuation — referred to as its market capitalization — but the share price becomes more accessible to investors.
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This isn’t quite as big a deal as in prior years, when investors had to buy full shares of stock to own them, as now fractional shares are available for purchase. But investors often push up shares of stocks that split anyway because they are usually associated with good corporate news.
A reverse stock split, on the other hand, is the mirror image of a conventional, “forward” stock split. With a reverse stock split, investors actually end up with fewer shares, and the stock price is increased by a corresponding amount. This scenario typically only happens during times of great financial stress for companies.
Here’s a quick look at exactly how a reverse stock split works, why companies use them and what it ultimately means for current and potential investors.
What Exactly Is a Reverse Stock Split?
A reverse stock split occurs on an exchange basis, such as 1-10. When a company announces a 1-10 reverse stock split, for example, it exchanges one share of stock for every 10 that a shareholder owns. So, if you own 1,000 shares of stock, after a 1-10 reverse stock split, you’ll end up with just 100.
But the total value of your holdings will remain the same. In this example, if your stock was worth $1 before the reverse stock split, it will become $10 afterwards. So, instead of owning 1,000 shares of a $1 stock, with a total value of $1,000, you will own 100 shares of a $10 stock, while maintaining the same $1,000 value.
What Would a Company Choose To Reverse Split Its Stock?
The primary reason companies choose reverse splits is to increase their stock price. It’s not very prestigious for a company to have a share price in the low single digits, and it’s often a sign of economic distress for a company. To remove this stigma, some companies choose to enact a reverse split.
Of course, this is an artificial way to increase a company’s share price, and most market participants see right through this machination. That’s why a reverse stock split is usually an option of last resort, if a company doesn’t see any other way to increase its stock price.
On a practical level, a reverse split can help a company avoid some seriously negative repercussions. For example, the New York Stock Exchange will delist a company if its price falls below $1 for 30 consecutive trading days. Many mutual funds and other institutional investors aren’t allowed to purchase stocks below certain price levels as well. A reverse stock split can at least temporarily avoid these ramifications.
Is a Reverse Stock Split Good or Bad?
Nothing in the financial world is inherently “good” or “bad.” In a market environment, one person’s treasure is another’s trash, and what loses money for some investors can make money for others on the opposite side of that trade.
However, as the stock market is primarily dominated by bullish investors looking for stock prices to rise, a reverse stock split is generally viewed as a harbinger of bad news. For this reason, stocks that undergo a reverse split often face increased selling pressure even after the split has occurred, as long-term holders flee the bad news and short sellers attack the stock, hoping it will continue to fall and provide them with a good profit.
Quite often, companies that decide on a reverse stock split are facing delisting or possibly even bankruptcy, and having a higher share price can help keep them afloat. But sometimes even well-known, prestigious companies can follow that path — although it’s usually when they too are experiencing financial distress.
Reverse Stock Split Examples
In 2002, for example, AT&T underwent a 1-5 reverse stock split, boosting its share price to $25. This marked the first time in history that a stock in the Dow Jones Industrial Average conducted a reverse stock split.
General Electric is another example. At one time, the company was considered one of the safest and most reliable stocks in the world. However, GE has struggled for decades now, and the all-time high in its share price was way back in August 2000, at $257.10. In an effort to boost its stock, the company reverse split its shares 1-8 in 2021. But even that tactic has not helped it. Shares traded above $103 after the split went into effect but have since fallen to just over $66, representing about a 36% loss since then.
The bottom line is that while any reverse stock split may work out, the truth is that it’s usually a negative sign rather than a positive one, at least for bullish investors. Even name-brand companies that perform the conversion rarely benefit in the long run, unless their business truly recovers.
Should I Sell if I Know a Reverse Stock Split Is Coming?
There’s no universal answer as to whether or not you should sell if a reverse stock split is coming, because there are too many variables. For the average long-term investor, a reverse stock split is generally considered bad news, because it implies that a company needs to raise its share price and it doesn’t feel it can do so organically on the open market.
But then again, much of this news may already be factored into the stock price, which has likely fallen by a large amount. If the reverse stock split is part of some grand company restructuring that seems likely to succeed in the long run, then it may prove to be a buying opportunity. However, historically speaking, this has been the exception rather than the rule.
If you’re a short seller, or an investor who bets on share prices falling, a reverse stock split may actually prove to be an opportunity for you. Anticipating that further losses may be ahead for a company forced to undergo a reverse stock split, a short seller may profit by selling shares now and buying them back at a lower price in the future.
Ultimately, the decision to buy or sell shares ahead of a reverse stock split will depend on your personal investment objectives and risk tolerance, along with an analysis of the business fundamentals of the underlying company.
Takeaway
A reverse stock split doesn’t change the underlying financials of a company, at least in terms of market capitalization. But it does make a difference in terms of market price and outstanding shares. It also affects market perception, which is perhaps the most important factor of all.
As an investor, whether a company is undergoing a reverse stock split or not, it’s important to evaluate its underlying fundamentals to see if it offers the opportunity for long-term growth. If not, it’s not a good investment regardless of its share price, at least for the traditional buy-and-hold investor.
FAQ
Who benefits from a reverse stock split?
The company might benefit from a reverse stock split, if it is able to recover from the associated negative market perception. A reverse stock split might, for example, allow a company's stock to remain listed on the NYSE – but that only helps if investors still want to buy.
Experienced and market-savvy short sellers might also benefit, but this is not a strategy that works for everyone and is very high-risk.
Do you lose money on a reverse split?
No, you don't lose money directly because of a reverse stock split. While the number of shares you hold decreases, their individual value increases, leaving you with the same value overall. However, companies that reverse split their stock often do so because they are struggling financially and may be losing value anyway.
What happens after a reverse stock split?
After a reverse stock split, shareholders each hold fewer shares of stock, but each share is worth proportionally more. There are no further direct effects, though the success of the company depends on many additional factors.
This article originally appeared on GOBankingRates.com: What Is a Reverse Stock Split?
