What is a Reverse Stock Split?
A reverse stock split is a corporate action that reduces the number of a company’s outstanding shares to increase the per-share price proportionately. This process consolidates multiple existing shares into fewer (higher-priced) shares. For instance, in a 1-for-5 reverse stock split, five existing shares would be merged into one new share. This action is essentially the opposite of a stock split, where shares are divided into more parts.
Key Takeaways
- Consolidation: A reverse stock split merges existing shares into fewer but pricelier shares.
- No Impact on Value: The company’s value remains unchanged; only the stock price increases.
- Distress Signal: It can signal financial distress, as it often seeks to elevate the price of low-value shares.
- Relevance: Companies use this strategy to stay relevant and avoid delisting.
Understanding Reverse Stock Splits
Companies utilize reverse stock splits mainly to elevate a low share price without creating any real value. The increased price per share often results in ratios like 1-for-2 or even 1-for-100, depending on the company’s strategy.
A reverse stock split generally indicates that a stock has lost significant value, often leading to further selling pressure. This corporate action requires the consent of shareholders, who vote on the proposal.
Advantages and Disadvantages of Reverse Stock Splits
Advantages
- Prevention of Delisting: Keeping the share price above specific minimum requirements to avoid delisting from major stock exchanges.
- Attraction of Big Investors: Higher share prices can attract institutional investors who avoid low-priced stocks.
- Regulatory Satisfaction: Reducing the number of shareholders to fit under preferred regulatory frameworks.
- Boost for Spinoff Prices: Companies can leverage a higher share price to gain better prices for spinoffs.
Disadvantages
Reverse stock splits are often negatively perceived. They signal that the share price has significantly dropped and the company is artificially inflating it without any substantive business improvement. Additionally, the reduction in shares can negatively impact liquidity.
Example of a Reverse Stock Split
Suppose a pharmaceutical company with 10 million shares trading at $5 each initiates a 1-for-5 reverse stock split. Post-split, the company would have 2 million shares trading at $25 each. Although the share price has increased, the company’s overall market capitalization remains consistent at $50 million.
Real-World Example
In 2002, AT&T performed a 1-for-5 reverse stock split alongside plans to spin off its cable TV division and merge it with Comcast. This move was aimed at preventing a potential decline in share price and ensuring financial stability.
Why Do Companies Undertake Reverse Stock Splits?
- To prevent delisting due to falling below minimum price requirements.
- To make the stock more attractive to non-penny stock investors.
What Happens If You Own Shares That Undergo a Reverse Stock Split?
Shareholders will see the number of shares they own decrease but the price per share increase correspondingly. For example, in a 1:10 reverse stock split, if you hold 1,000 shares at $5 each, post-split, you would have 100 shares at $50 each. This is managed automatically by brokers.
Are Reverse Splits Good or Bad?
Reverse splits often carry a negative connotation as they signal substantial share price declines. The post-split higher prices may deter certain retail investors who typically prefer lower-price stocks.
Why Do ETNs Have Frequent Reverse Splits?
Exchange-traded notes (ETNs) often decay in value over time, necessitating regular reverse splits as they hold derivatives rather than the actual underlying assets, making them unsuitable for long-term holding.
The Bottom Line
A reverse stock split consolidates shares without affecting a company’s total value. While it can temporarily inflate a share’s price, it doesn’t create real value and is frequently a last-ditch effort to maintain market presence. Buyers beware, as these actions often signify underlying financial issues within the company.
Related Terms: Stock Split, Capital Structure, Market Capitalization.
References
- Nasdaq. “5500. The Nasdaq Capital Market”.
- AT&T. “AT&T Corp. Historical Stock Split Data”.
- Internal Revenue Service. “Stocks (Options, Splits, Traders) 7”.
