What is a Reverse Stock Split?

A reverse stock split is like taping a piece of paper back together after cutting it…

You need some paper to take notes on, so you get a piece of paper and cut it into eight pieces so you have more individual pieces to work with. You later decide that you’d prefer to have fewer, larger pieces of paper than more, smaller pieces, so you tape the paper back together into two pieces, each composed of four small pieces. You have the same amount of paper overall, but in fewer sheets.

A reverse stock split is similar. You “tape” multiple shares together into one. Each share represents the same amount of ownership as the original number of shares that combined to make the new share.

A reverse stock split reduces the number of shares in a company by dividing each share into a fraction of a share. It’s the opposite of a stock split, which increases the number of shares outstanding.

For example, a company that has two million shares outstanding could do a reverse stock split that turns every share into half of a share. This would reduce the number of shares outstanding to one million.

When a reverse stock split occurs, existing stockholders keep the same amount of ownership in the company. If a stockholder holds two shares in a company with one hundred total shares, they own two percent of the firm. If the company does a reverse split to halve the number of shares outstanding, that stockholder will now own one out of 50 shares — which is still two percent of the firm.

Reverse stock splits tend to increase each individual share’s price without impacting the overall value of the company. If a firm does a 4-for-5 split, turning five shares each worth $10 into four shares, the price of each new share of stock would be $12.50.

However, reverse splits sometimes have a negative reputation, which can lead to them causing drops in a business’s market capitalization.

In the past, reverse splits mostly occurred in very small companies that wanted to prop up their share prices. Between 1984 and 2000, only one company in the top three hundred by market capitalization underwent a reverse split. Eight-five percent of reverse splits happened in companies with market capitalizations under $100M.

With the financial pressures caused by the early 2000s financial downturn, larger companies began using reverse splits. For example, AT&T, then in the Dow Jones Industrial Average, did a reverse split in 2001.

While reverse splits are more common for small firms, larger companies have used them as needed. For example, Citigroup used a reverse split in the wake of the 2008 financial crisis to help keep its share price high.

Companies may opt for a reverse stock split for a variety of reasons.

One is to try to make sure that its share price remains above a threshold. Many investors are wary of cheap stocks, especially those below $5 or $1 (penny stocks). Penny stocks have a reputation for high risk, so established companies often try to keep their per share price high enough to avoid the penny stock label.

Companies may also do a reverse split to increase their share price before spinning off a portion of the business. This helps both the original business and new spinoff maintain reasonable per-share values.

Also, some stock exchanges or indices have minimum share price requirements. When a company is removed from an index or delisted from a stock exchange, it can have a significant impact on its share price and appeal to investors. Reverse splits can help businesses on the cusp of falling below these requirements stay in compliance and remain listed on an exchange or in an index.

In theory, a reverse stock split shouldn’t have an impact on the market value of a company.

If a business is worth $10B, it should not matter how many shares in the company exist. If there are 10B shares, each should cost $1. If there are 100M shares, each should cost $100. A reverse split reduces the number of shares in a company without altering its underlying financials. That means that a 2-for-1 split should double a share’s value because it halves the number of shares that exist. A 4-for-5 split reduces the number of shares by 20%, so each share should rise in value by 20%.

In practice, reverse stock splits tend to have a bad reputation. Many companies that use reverse stock splits use them to try to prop up their share value when it’s dropping. This is especially true when the company wants to avoid falling out of index or getting delisted from an exchange. Research has shown that most companies that undergo a reverse split offer lower returns than companies that don’t split.

In theory, a reverse stock split is neither good nor bad. It’s a tool that a company can use to set the prices for its shares without affecting the value of the company itself.

In reality, reverse stock splits usually end poorly for the business going through the split. Many of the incentives for a reverse split have negative implications for the company, such as a share price that is already falling or a desire to make a cheap company appear more legitimate by boosting its share price.

There’s nothing stopping a company going through a reverse split from succeeding and gaining value over time. However, stocks that do reverse split tend to lag behind the market.

The advantage of reverse stock splits is that they give a firm’s management a way to increase the price of the company’s shares. There are many reasons to want to increase a stock’s price, including staying listed on an exchange or qualifying for an index, and reverse stock splits are a useful tool in maintaining the required prices.

Reverse stock splits can also help a company consolidate its ownership. If there are many people who own just a share or two in a firm, the company can use a reverse stock split to reduce those owner’s holdings to fractions of a share. They can then pay those owners out and reduce the number of individuals who have a stake in the company.

A disadvantage of reverse splits is that they can reduce the liquidity of a share. More investors can buy shares that cost $10 each on the stock market than shares that cost $100, which means cheaper shares tend to be more liquid. Reverse splits increase share prices, which makes them harder for some investors to buy.

Reverse stock splits also have a bad reputation and can cause the company’s market capitalization to fall.

All investing is subject to risk, but some investors rely on different strategies that they believe increase their chances of profit and reduce their potential losses.

Because companies that reverse split tend to lag behind the market, one option is to short companies undergoing a reverse split. Shorting a stock means that you earn money if the stock loses value.

Another strategy is to hope that the company’s reverse split works, helping it remain listed on an exchange or in an index, and that its share price recovers. If you feel confident in a company undergoing a reverse split, you can take the opportunity to buy shares and hold them if they appreciate.

Many companies undergo stock splits or reverse splits.

For example, in 2017, after splitting off its business process outsourcing business, Xerox Corp. undertook a 1-for-4 reverse split, reducing the authorized shares of its common stock to 437.5M shares from 1.75B shares.

LendingClub Corporation, a peer-to-peer lending company, undertook a 1-for-5 reverse stock split in July of 2019. Its stock price had fallen precipitously since its IPO in 2014, following technological and management troubles. The reverse split helped bolster the stock price from under $5 a share to a stock price hovering above and below the teens until January 2021. The stock price peaked at $49.21 in October 2021; however, the stock price has fallen further since then, back to around the $11 mark as of September 2022.

Aurora Cannabis experienced a 1-for-12 split in April of 2020 in an effort to boost its stock price that was around the $10 mark at that time. In addition to the reverse stock split, the company has implemented several other measures, such as divesting from non-core cannabis operations, to improve its financials. However, Aurora Cannabis still has plenty of room for improvement as the stock price traded slightly above $1 as of September 2022.

More recently, in 2021, GE underwent a 1-for-8 reverse split. The company reduced its total number of common shares from about 8.8B to about 1.1B. With over 125 years of operation, GE continues open for business with a market capitalization of more than $68.80 billion as of September 2022.