If you’re a trader or investor, you’ve probably heard the term “reverse stock split.” But what is a reverse stock split and what does it mean for you?
In this post, we’ll discuss everything you need to know, including what they are, how they work and explore some of the pros and cons so you can decide for yourself if they’re right for your portfolio.
A Reverse Stock Split Explained
A reverse stock split is when a publicly-traded company decreases the number of its outstanding shares by consolidating them and thereby increasing the stock price share.
For several reasons, a reverse split can be done to increase the price per share so it meets a certain threshold, such as $1, or to make it easier for the company to buy back its shares.
If you own shares of a company that does a reverse split, your number of shares will decrease, but the price per share will increase in proportion. For example, if you own 1,000 shares of a company with a par value of $0.01 and the company does a 1-for-2 reverse split, you will end up with 500 shares with a par value of $0.02.
Note that reverse splits are relatively rare. If a company is considering a reverse split, it will usually do a 1-for-2 or 1-for-3 split. More drastic measures, such as a 1-for-10 split, are very unusual.
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Types of Reverse Stock Split
There are three types of a reverse stock split: pro-rata, odd-lot, and combination.
Pro-rata Reverse Stock Split
It is the most common type. It’s a 1-for-2, 1-for-3, 1-for-4, or 1-for-5 split in which all shareholders receive the same proportionate number of new shares.
So, if you own 100 shares before the split and it’s a 1-for-2 split, you’d own 50 shares after the split.
Odd-lot Reverse Stock Split
This is less common. It’s usually a 1-for-3 or 1-for-5 split in which shareholders who own fewer than a certain number of shares, typically 100 or 200, are cashed out at a set price per share.
So, if you own 75 shares before the split and it’s a 1-for-3 split with a cash-out price of $30 per share, you’d receive $2,250 in cash and 25 shares after the split.
Combination Reverse Stock Split
It is the least common type. It’s a 1-for-2, 1-for-3, or 1-for-4 split in which shareholders who own more than a certain number of shares, typically 100 or 200, receive new shares while shareholders who own fewer than that number are cashed out at a set price per share.
So, if you own 150 shares before the split and it’s a 1-for-2 split with a cash-out price of $30 per share, you’d receive 75 shares after the split and $4,500 in cash.
The key thing to remember is that, regardless of the type of reverse stock split, the total value of your investment will remain the same.
Why Do Companies Do Reverse Stock Splits?
There are a few reasons why companies might do reverse stock splits. Below you can find some of the most common.
To Avoid Being Delisted
The most common reason companies will do reverse stock splits is to avoid being delisted from a major stock exchange like the New York Stock Exchange (NYSE) and Nasdaq. All exchanges have rules about the minimum stock price requirement that a company’s stock can trade at.
If a company’s share price falls below that level and stays there for a certain period of time, usually 30 or 60 days, the exchange will warn the company that it’s in danger of being delisted.
At that point, the company has two choices: it can try to increase the stock price through traditional means like improving its business fundamentals or doing a share buyback, or it can do a reverse stock split.
If the company chooses the latter option, it’s usually because its business fundamentals are weak and it doesn’t think it can boost the stock price through other means.
In that case, the reverse stock split is simply a short-term fix that allows the company to stay listed on the exchange and avoid the negative publicity that would come with being delisted.
To Attract Investors
If a company’s share price falls into the single digits per share or lower, investors may look at the shares as a penny stock. Another reason companies do reverse stock splits is to make their stock more attractive to investors.
A company with a share price of $0.50 might not look as appealing to potential investors as a company with a share price of $5.00, even though the two companies might have the same market capitalization.
So, by doing a reverse stock split, a company can artificially increase its share price and make itself look more attractive to potential investors. Of course, this is just a short-term gimmick and doesn’t do anything to improve the underlying business.
To Increase Liquidity
Some companies do reverse stock splits simply to increase the liquidity of their stock. If a company has a large number of shares outstanding, each individual share might not trade very often. As a result, it can be difficult for shareholders to buy or sell the stock.
By doing a reverse stock split and reducing the number of shares outstanding, the company can make its stock more liquid and easier to trade.
Disadvantages of Reverse Stock Splits
While there can be some benefits to a reverse stock split, there are also several disadvantages that traders and investors should be aware of:
- It can signal that the company is in trouble. If a company is struggling to stay afloat, a reverse stock split might be seen as a last-ditch effort. This can make shareholders lose faith in the company and sell their shares.
- It can be a sign of insider trading. If insiders know that a reverse stock split is coming, they might buy shares before the split and sell them afterward for a profit. This can leave other shareholders worse off.
- It can be dilutive. If a company does a reverse stock split and then issues new shares, this can be dilutive for existing shareholders.
- It can be a waste of time and money. If a company does a reverse stock split and doesn’t address the underlying problems that caused the low share price in the first place, it’s not going to solve anything.
As you can see, there are both pros and cons to a reverse stock split. Ultimately, it is up to the individual company and its shareholders to decide if a reverse stock split is a right move.
If you are an investor in a company that is considering a reverse stock split, be sure to do your research and understand all of the potential implications before making a decision.