If faced with the proposition of owning one share of company stock for $50 or two shares for $25, you might wonder what difference it makes. In a reverse stock split, the amount of shares decreases, but your investment doesn’t lose value. However, reverse stock splits can be ominous for investors as a company tries to inflate its stock price and keep investors engaged. If you’re looking for help with investment choices, consider working with a financial advisor.
What Is a Reverse Stock Split?
A reverse stock split is when a company merges shares of stock to create a smaller supply of more expensive shares. As a result, every shareholder experiences a reduction in the number of shares they hold, but the value of their investment is unchanged.
Reverse stock splits are generally part of a company’s broader strategy to increase share value and attract investors. By making shares of stock scarcer, the company pumps up share prices and enhances its ability to remain on major stock exchanges.
How Reverse Stock Splits Work
Reverse stock splits might divide the number of existing shares by half or even by one hundred. While this action doesn’t reduce a company’s market capitalization, it may result from recent financial problems.
Reverse stock splits don’t change the value of your investment, but they do decrease the number of shares you hold. For example, you might initially have 50 shares worth $10 each. However, after a one-for-ten reverse stock split, the company would divide your shares by ten. As a result, you would have 5 shares worth $100 each.
Stock Split Example
The 2008 financial crisis struck a devastating blow to the banking industry and Citigroup, the parent company of Citibank, was no exception. Layoffs began at the company in the summer of that year as it reeled from the tanking housing market. Its market capitalization shrunk from $300 billion to $6 billion. In addition, by early 2009, its stock value plummeted from a previous high of $557 to less than $1 per share.
Although Citigroup received the largest amount of bailout money among America’s big banks, it struggled to become profitable. Then, amidst several additional business strategy changes, it issued a one-for-ten stock split in May 2011. The bank consolidated its shares, tightened operations and has since become profitable. Now, more than ten years later, it trades for almost $50 per share.
Pros and Cons of a Stock Split
A stock split can provide a boost to a stock’s position in the stock exchange and it can help a company appeal to its own investors. However, it can also provide a negative impact to a company’s stock and decrease the total liquidity of the business. Here are the pros and cons of a stock split.
Pros of a Stock Split
- Maintain a position in the major stock exchanges: For example, Nasdaq and the New York Stock Exchange frequently delist stocks that trade for less than $1 per share consistently for a month. As a result, a reverse stock split can increase the share price exponentially and help a company retain visibility on the most popular exchanges.
- Appeal to investors: Investment firms and financial institutions often follow minimum stock price policies. Because they overlook companies whose stock prices are too low, a reverse stock split can help a company stay viable for trading among large investors.
- Change regulations: Investment laws apply differently to companies with fewer investors. So, a reverse stock split can encourage shareholders to sell off their stock and help bring a company to its desired number of shareholders and corresponding rules.
- Enhance starburst prices: Companies occasionally detach a portion of their business into a separate, independent company called a starburst or spinoff. In this scenario, the original company might have floundering stock prices and want to secure a better price for its spinoff. As a result, it will perform a reverse stock split to raise its own stock price and that of its new company.
Cons of a Reverse Stock Split
- Can ruin investor confidence: Because a reverse stock split typically occurs because of weak stock prices, investors might interpret it as a desperate move from a deteriorating company.
- Decreases liquidity: The split reduces the number of shares available, giving investors fewer opportunities to trade the company’s shares. In other words, a reverse stock split can drive down trading activity since shares become scarce.
Reverse Stock Splits vs. Regular Stock Splits
A reverse stock split and a regular stock split preserve the overall value of shareholders’ positions, but they have opposite results for the amount of stock. Specifically, reverse stock splits reduce the number of shares available by a certain proportion.
For example, the number of shares might be cut in half and the value of each share double. So, ten shares at $5 each become five shares at $10 each. The value of the investment stays constant ($50 for a hypothetical shareholder).
On the other hand, a regular stock split increases the number of shares available. For example, a company conducting a three-for-one regular stock split divides each share into three shares. So, a shareholder with ten shares at $5 each will have thirty shares at $1.66 per share, preserving their $50 position.
Why Companies Perform Reverse Stock Splits
Reverse stock splits usually occur because a company’s stock price has tumbled. A company may have a series of bad quarters, failure in leadership or struggle to keep up with financial projections. Investor confidence is down and the company’s future is in question.
In response, such troubled companies may take several steps to recalibrate:
- Firing and rehiring top-level employees.
- Refreshing their business strategy.
- Performing a reverse stock split to keep the share price healthy.
As part of a broader effort to stabilize the company, a reverse stock split boosts share prices and can help investors feel assured. In addition, a company will perform a reverse stock split to maintain its presence on the major stock exchanges and bolster the value of spinoff company stock.
The Bottom Line
A reverse stock split reduces the number of shares of company stock available and raises the stock price so the value of investments is unaffected. Companies do this to prevent stock prices from tumbling to dangerous levels while they work to improve operations and profits. However, investors often see reverse stock splits as signs that companies are in dire straits. That said, if employed as part of a larger business strategy, a reverse stock split can help a company pull out of a financial nosedive and keep investors on board.
Tips for Reverse Stock Splits Investing
- Predicting a company’s success depends on more than a reverse stock split or one profitable quarter. Market research is multifaceted, and investing in individual companies can be challenging. Fortunately, you don’t have to go alone. You can work with a financial advisor who can help you manage your investment choices. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Stock splits might affect how you feel about your investment. However, corporate action can affect your stock in multiple ways. For example, while not identical to a stock split, stock dilution might influence your holdings in a company.
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