Discussion Topic: Reverse Stock Split
In this tutorial, we will learn about the reverse stock split. How does it work? Why companies do a reverse stock split? What are the consequences? What are the effects of a reverse split on share price and stock market? And is it good or bad for the investors? - A must-know topic for every investor.
What is Reverse Stock Split? - Definition
A reverse stock split is a management decision in which a company reduces the total number of its outstanding shares, increases the price, and increases the face value of the stock. It is the total opposite of Forward Stock Split.
A reverse stock split involves the company merging its current outstanding shares in a pre-defined ratio. It is either denoted as a ratio such as 1:5, 1:10 or denoted as a statement like 1-for-5, 1-for-10 etc.
A reverse stock split is also known by some other names such as stock merge, stock consolidation, or share rollback.
Though the share price increases after a reverse stock split is done, it doesn't add any real value to the investors as the total share capital would remain unchanged. Usually, the primary objective of this action is to avoid a situation of getting delisted from a major stock exchange or stock index, and to reduce the general negative impression of being a penny stock.
How the Reverse Stock Split Works?
When a company executes a reverse split, it calls off its current outstanding shares and distributes new stock shares to its shareholders in a proportion to how many shares an investor hold before the reverse stock split.
For example, in a 1-for-10 reverse stock-split, shareholders receive 1 share of the company's new stock for every 10 shares they were holding. If an investor previously owned 100 shares, he would now own 10 shares after the reverse stock split.
To understand it more clearly, let us assume that Company X has 100 million outstanding shares with a face value of $2 per-share and market value of $10 per-share. Now the company decides to undergo a reverse stock split of 1-for-5 (1:5). So, what would now happen is that:
It would reduce the total number of outstanding shares to 20 million (i.e. - 100 / 5 = 20 million), it will also increase the face value of stock to $10 ($2 x 5 = $10) per-share, and the share of this company would now trade at a market price of $50 per-share ($10 x 5 = $50).
Hope, now it is clear to you…
If you are still unsure about how it works or don't want to do such calculations, we have developed a solution for you. You can instead download and use our "Stock Split Calculator App" to do that hardwork for you. You can calculate forward stock split and reverse stock split with a touch of a single button. Click on the App Image to download it from Google Play Store.
Reasons for Performing Reverse Stock Split:
There can be many reasons behind the decision of doing a reverse stock split. Some of the most common reasons are listed below.
- The company may desire to increase the share price, especially if the share price falls down to a category of penny stocks. As low prices tend to evoke a negative perception among the investors, this action may help to change the perception.
- Companies looking for a spinoff may use reverse stock-split to make the price attractive enough for investors. It is especially taken just after a separation between two collaborative companies.
- If the share price of a company falls well below the average share price compared to its peer companies, then the decision for a reverse stock split can be carried to bring the stock price to that average level.
- Major stock exchanges have a defined minimum share price for the price of the stocks to be listed publically. So, to stay enlisted, a low-priced stock may perform reverse split in order to appraise the stock price above the minimums.
- The last reason for a reverse stock split may just be an attempt to extend the life of a shrinking company in a hope for a good time.
While the last two reasons are extremely negative in nature, the first three can be considered as positive strategies if the company has strong fundamentals and the company management is confident about its turnaround. Hence, it's an investor’s duty to analyze the fundamentals of such companies before taking a decision on further investments.
The Effect of a Reverse Split on Share Price and Share Capital:
Theoretically, a reverse stock-split does not affect the company's value, so the company's total market capitalization remains the same even after the reverse split. The only difference it makes is that the company now will have fewer numbers of outstanding shares.
Though the share price increases in direct proportion to the reverse stock split, the total value of the shares an investor owns remains unchanged. If an investor own 500 shares worth $10 each prior to a one-for-2 reverse stock split, after the reverse-split the investor would have 250 shares worth $20 each. The total value of shares the investor owns will still be the same $5,000. This is same as exchanging five $10 currency notes for one $50 currency note.
Effect of a Reverse Stock Split on Stock Market:
Reverse stock splits are usually interpreted as a negative approach by the market. Also, the general investors see this as a forthcoming danger. Hence, it may witness an immediate heavy selling pressure. But this gets neutralized in long-term, as the reverse-split reduce the outstanding shares and liquidity, it gets harder for short seller to short the stock frequently. The reduced liquidity can also widen the Bid/Ask Spread, which will farther reduce the trading and short selling frequency.
However, there are some benefits of a reverse stock split. First of all, boosting the stock price to a certain level can attract more long-term investors. Secondly, it provides the company more time to strategically improve their performance.
Though very rare, the reverse stock split also has few success stories. Such as, in 2009, American International Group Inc (AIG) was trading at $1.16 when they decide to undergo a 1-for-20 reverse split. Presently the stock is trading over $50 per share.
Despite few occasional success stories, reverse stock splits aren't usually a good sign for a stock. Hence, invest only if you are sure about strong fundamentals and positive strategic changes.
We hope that you have enjoyed the above article describing the reverse stock split. Be with us to explore forex trading, stocks trading, and other money-making opportunities.
Leave us some comments if you have any questions or doubts about reverse-split and also, let us know what you think about it (as an advantage or disadvantage for investors).