A reverse stock split is a corporate action that reduces the total number of outstanding shares of stock in favour of a smaller number of more valuable shares.
In a 1-for-5 or 1-for-10 reverse stock split, for example, the total number of shares in circulation is reduced by five or ten.
The opposite of a stock split, in which one share is divided into several, is a reverse stock split, which may also be referred to as a stock consolidation, stock merge, or share rollback.
KEY PHRASES
- Shareholders’ current stock holdings may be reduced through a reverse stock split.
- The value of a company (as opposed to the stock price) is unaffected by a stock reverse split.
- Since the value of shares that would otherwise be cheap is increased, this can be an indicator of a troubled company.
- The most common reasons for a company to take this course of action are to maintain market relevance and prevent delisting.
How Reverse Stock Splits Works
Capital structures can be affected by a variety of corporate-level actions taken by companies in response to changes in the market and other external factors.
To create a smaller number of shares that are proportionally more valuable, a company may implement a reverse stock split.
When a company reduces the number of shares it has issued, the price per share rises because the company is effectively selling less of its stock.
Companies choose reverse stock splits primarily to increase the per-share price, and the associated ratios can range from one-for-two to one-for-hundred.
Although reverse stock splits typically occur after a company’s stock has lost significant value, they have no effect on the value of the company as a whole.
The stock price usually drops again as a result of the negative publicity surrounding such a move.
The Pros and Cons of a Stock Reverse Split
A company may choose to reduce its number of outstanding shares in the market for a variety of reasons, some of which are positive.
Pros
Prevent major exchange removal: If the price of a company’s shares has fallen to an all-time low, the company may be at risk of further market pressure and other unfavourable developments, such as failing to meet the exchange’s listing requirements.
A stock must meet the minimum bid price established by the exchange in order to be listed.
If the stock price stays below the minimum bid price for a prolonged period of time, the exchange may decide to delist the stock.
If a stock is consistently trading at less than $1 per share, for instance, Nasdaq may decide to delist it.
If a stock is delisted from a major exchange, it becomes a penny stock and must be listed on the pink sheets.
Stocks that have been relegated to these “alternative markets for low-value stocks” are more difficult to buy and sell.
Attract big investors: Many companies use reverse stock splits to keep share prices above a certain minimum value, which is set by the policies of institutional investors and mutual funds.
Failure to attract such large investors can damage a company’s trading liquidity and reputation, even if the exchange doesn’t delist it.
Please regulators: The number of shareholders is just one factor in determining how a company is governed in various countries around the world.
Companies may choose to reduce the number of shares outstanding in order to bring themselves under the jurisdiction of a more favourable regulatory body or set of laws.
Going private companies may also try to reduce the number of shareholders in this way.
Boosts Spinoff prices: A spinoff is a new company formed from the sale or distribution of existing shares in an existing business or division of a parent company.
If, for instance, the parent company’s stock is trading at low levels, it may be challenging for the spinoff company to price its shares at a higher level.
Reverse splitting the shares and increasing the value of each individual share could solve this problem.
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Cons
Investors and traders typically view a reverse stock split negatively.
It means the stock price has hit rock bottom and management is desperately trying to boost prices without a solid business case.
Reducing the number of shares available on the market could also have an adverse effect on the stock’s liquidity.
Conclusion
A reverse stock split, stock consolidation, stock merge, or share rollback is the process by which a publicly traded company reduces the number of outstanding shares.
The merger does not lower the value of the company. If there are 5,000,000 shares trading at $10 each, a 1-for-5 reverse split would cause 500,000 shares to trade at $50 each.
Inflating the price of a stock without adding value to the company is a common criticism of reverse stock splits.
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