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A company that wants to increase its stock price might decide to issue a reverse stock split. However, since the value of the company remains the same, this is more of an accounting trick than anything else.
A reverse stock split reduces the number of shares a company owns, increasing the price per share, but the total value of the shares remains the same.
Let’s get into the details of what a reverse stock split entails and why companies can go through a reverse stock split. Let’s dig deeper and learn more.
The short version
- A reverse stock split is when a company consolidates its total number of shares, but the stock price increases due to the reduced number of shares.
- Companies undergo a reverse stock split for a number of reasons, such as to remain publicly traded or to avoid negative investor perceptions.
- Although a reverse stock split does not affect the value of a company, it can mean that the company is facing problems. Investors should do their research and due diligence to determine whether they should make any moves.
What is a reverse stock split?
A reverse stock split is when a company consolidates its existing stock into fewer, more expensive shares. The result makes the price of each stock higher, not because they are necessarily worth more, but because of simple math.
The market capitalization and total value of the shares remain the same during a reverse stock split. It changes the number of shares each investor owns and the value of each share. Stock splits are also called stock consolidations, stock mergers, or stock pullbacks.
A reverse stock split is the opposite of a stock split when a stock is split into several parts and the price per share decreases.
Read more >>> Investment terms and definitions you should know
How a reverse stock split works
In a reverse stock split, the company’s outstanding shares are split by a number such as five, ten, or even 100. This causes the stock price to increase proportionately.
For example, a 1:10 reverse stock split divides a company’s stock by 10, and the value of each share will increase by a factor of ten. So if you own 10,000 shares, you would only have 1,000 shares after the split. But the shares would be worth the same as when you had 10,000.
The company’s board of directors must approve the reverse stock split, subject to shareholder approval. Once approved, the company will announce the split and include information such as the split ratio and date. The company will cancel its outstanding shares and distribute pro rata new shares to shareholders on that date.
Why Companies Undergo Reverse Stock Splits
There are a few reasons why a company might issue a reverse stock split. The most common reason is to avoid being delisted from a stock exchange such as Nasdaq or the New York Stock Exchange (NYSE). For a company to stay on the NYSE, for example, it must trade above $1. If the share price falls below $1 for a certain amount of time, the stock exchange could delist it.
Companies can also use reverse stock splits to avoid negative investor perceptions. The lower stock price may cause investors to decide to sell their shares. The increase in the company’s stock price can also help it retain favor with large institutional investors who may have restrictions related to investing in delisted stocks.
However, investors do not always receive reverse stock splits favorably. A reverse split usually indicates that the stock price is near the bottom and could indicate that the company is struggling. Also, if there is a small number of shares available, it can hurt the company’s liquidity.
GE Reverse Stock Split
General Electric declared a 1:8 reverse stock split in 2021, which reduced its outstanding shares from 8.8 billion to 1.1 billion. It issued the split as it struggled after selling off part of its business and its stock price fell more than 50% from its peak in 2016. The company declared a reverse stock split to match its business reduction This move did not convince shareholders and the company’s stock continued to fall.
SoFi Reverse Stock Split
In July 2022, SoFi shareholders approved a proposal that gives the company’s board the authority to enact a reverse stock split if they believe it would be beneficial. If reverse division were to occur, it would fall within the range of 1-2 to 1-10. Many analysts have discouraged SoFi’s board from accepting the proposal, but so far no public announcement has been made either way.
How to profit from a reverse stock split
There are two main ways that investors I could make money with a reverse stock split. One way is to buy shares of the company before the reverse split occurs with the plan to sell them soon after. This can be profitable if the company’s stock price rises after the split.
Another way to make money from a reverse stock split is to short sell the company’s stock. This involves selling shares of the company’s stock you don’t own and then buying them back at a lower price after the split. This can be profitable if the company’s stock price declines after the split.
However, both of these strategies are risky. In the first case, there is no guarantee that a value will increase after a reverse split (in fact, there is a good chance that the opposite will happen). And short selling is an inherently risky way to make money in the stock market because there’s no limit to how much money you could lose on a position.
Pros and cons of a reverse stock split
pros
- Prevents a stock market drop
- It can increase investors’ opinion of the stock
- It can increase or maintain favor among influential investors
against
- Loss of liquidity
- Investors may see this as a sign that the company is struggling
Is a reverse stock split good or bad?
If a company you invest in announces a reverse stock split, you may be wondering how to profit and whether you should sell or buy more shares. The split itself will not affect you, as the value of your investment will remain the same even if the individual shares are worth more.
But the reason for the reverse stock split is important. Reverse stock splits often occur after a long decline in the stock price. Investors typically consider such news negative and may cause the company’s stock price to fall further after the split.
However, a reverse stock split can sometimes give a company time to get its operations back on track. This happened when travel giant Priceline, now Booking Holdings, did a 1:6 reverse split after the tech crisis of the early 2000s.
So whether or not a reverse stock split is good or bad depends on the circumstances surrounding the decision and the company itself. In each case, it is best to carefully read the materials provided and SEC filings to determine the reasons for the reverse split and the best course of action for your portfolio.
Read more >>> Risk/reward ratio: what it is and how to calculate it
The bottom line
When a company decides to perform a reverse stock split, the stock price increases but the number of shares decreases, all without changing their market value. Many troubled companies use this accounting trick to help them buy time or continue to trade on a stock exchange.
Many investors take a reverse stock split as a negative sign, but that’s not always the case. Sometimes, it can give the company the time it needs to get its operations in order.
Therefore, if you own stock in a company that has announced a reverse stock split, it is important to read the SEC and financial statements to determine the reason for the split. Then you can decide if the company is on the road to redemption or if it’s a sign of impending disaster.
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