What is a Reverse Stock Split?

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Definition:

When a company does a reverse stock split, it turns each share into a fraction of a share, for example, turning every two shares in the company into a single share.

🤔 Understanding reverse splits

A reverse stock split reduces the number of shares of stock available in a company. For example, a company could do a reverse stock split, turning every two shares in the firm into a single share. This gives the company some ability to influence its stock price, which can be important for qualifying for certain stock indices. Stock splits, whether traditional or reverse, do not directly change the value of a business or the level of ownership each stockholder has. They only change the number of shares outstanding, leaving each shareholder with an equivalent number of shares to what they owned before the split. However, reverse splits sometimes have a negative reputation, which can cause the values of companies undergoing reverse splits to drop.

Example

Say Company XYZ has 5 million shares outstanding, each worth $5. The company announces a reverse stock split where it plans to halve the number of shares outstanding. For every share someone owns, they’ll receive half a share.

Jane owns 10 shares worth a total of $50. When the reverse split occurs, Jane will now own 5 shares. Assuming nothing else changes, each share should be worth $10, because they each represent a larger portion of the company, which now only has 2.5 million shares outstanding.

Takeaway

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.

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What is a reverse stock split?

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.

What is the history of reverse stock splits?

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.

Why do companies go for reverse stock splits?

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.

What is the market impact of reverse stock splits?

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.

Is a reverse stock split good or bad?

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.

What are the advantages and disadvantages of reverse stock splits?

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.

How can you profit from a reverse stock split?

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.

What are some examples of reverse stock splits?

Many companies undergo stock splits or reverse splits.

For example, in 2003, Priceline.com underwent a 1-for-6 reverse split. The company (now Booking Holdings) remains successful with a market capitalization of more than 57 billion as of April 2020.

Citigroup experienced a 1-for-10 split in 2011 while recovering from the 2008 financial crisis. The company was able to eliminate shareholders who were more interested in frequently trading shares in the firm than in holding them for the long-term. The reverse split also made it easier to manage paying a dividend to shareholders, leading Citi to reinstate its dividend payment program.

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.

More recently, in July of 2019, LendingClub Corporation, a peer-to-peer lending company, undertook a 1-for-5 reverse stock split. 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 in the teens in late 2019; however, the stock price has fallen further since then, back to around the $5 mark as of May 2020.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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