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What Is a Reverse Stock Split and How Does It Work?

May 6, 2022
7
min

A reverse stock split reduces the number of shares outstanding, and raises the price of each individual share but it doesn’t change the value of a company.

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Earning higher profits is the surest path to a higher share price for publicly traded companies. But that isn’t always easy to achieve in a competitive market or for a company whose products or services have fallen out of fashion or become obsolete

There is one sure way to boost a share price quickly. It’s known as a reverse stock split.

What is a reverse stock split?

A reverse stock split, also called a stock consolidation, occurs when a company decides to exchange several of its shares for a single new share, which has the same value as the total of the consolidated shares. It’s a way for a company to artificially boost its sagging share price to make it look attractive to more investors, without changing its total market value.

Reverse splitting shares is the same idea as someone with 10 single-dollar bills going into a store and asking the cashier to exchange them for one $10 bill. There is no change in value.

Reverse splits reduce the number of shares outstanding by the split ratio. For example, 5 million shares outstanding become 1 million after a 1-for-5 consolidation. Regular splits, also called forward splits, do the opposite; a 5-for-1 split turns 1 million shares into 5 million. A regular stock split is done because a company is concerned that its share price has become too expensive.

Share prices also change by the split ratio. In a reverse split, one new share is priced at five times the old share, per the above example. In a regular split, it’s the opposite: each new share’s price is one-fifth the old share price.

Reverse splits happen predominantly among small-cap and startup companies that may be in early stages of business development, but some large-cap companies have done reverse splits after experiencing large share price declines.

How a reverse split works

A company will typically announce a reverse stock split through a news release, in which it will specify the split ratio and the effective date for the split.

For example, if ABC Inc. announced a reverse split of 1-for-10 and an investor owned 1,000 shares of ABC, which were trading at $2 a share for a total value of $2,000, the reverse split would leave the investor with 100 shares at $20 each. The value would be unchanged at $2,000.

Real examples of reverse stock splits

A number of companies, some of them well-known, have done reverse stock splits. These include:

  • General Electric, once a leading blue-chip company, did a 1-for-8 reverse split in 2021 after its shares fell as low as $5.50.
  • Citigroup, the big multinational bank, did a 1-for-10 reverse split in 2011 in the wake of the financial crisis.
  • American International Group did a 1-for-20 reverse split in 2009 after the insurer was bailed out by the U.S. government.
  • Motorola, the mobile phone maker, did a 1-for-7 reverse split in 2011 when it separated from the company’s telecommunications arm. 

What reverse stock splits can mean for investors

Companies that do reverse stock splits are often in some financial distress, with dim prospects for recovery. This may prompt investors to sell and move on. Reverse splits also can diminish or force out small investors, who may not have enough shares to be consolidated. For example, if a company decided on a 1-for-50 reverse split, any holders of fewer than 50 shares wouldn’t be offered a fractional new share. They would instead be paid cash for their shares. Similarly, holders of uneven share multiples would partly be paid cash; someone with 125 shares, for example, would get two new post-split shares and receive cash for the remaining 25.

Forward vs. reverse stock splits

A regular stock split, also called a forward split, is done by simple division. For instance, in a 10-for-1 split, one share that’s worth, say, $1,000, could be split into 10 shares worth $100 each.
A stock split like the above example typically comes when a company has enjoyed a period of growing sales and profitability, driving the stock price higher. Apple split 4-for-1, and Tesla split 5-for-1, in 2020. Amazon and Google parent Alphabet planned 20-for-1 splits in 2022.

Performance of stocks after a reverse split

Forward stock splits and reverse splits shouldn’t make any difference in value to the investor, since they are merely a rearrangement of the current value, not an increase or decrease.
But they do make a difference, generally in opposite ways:

  • Forward splits signal success, and post-split shares often continue to rise. With a more affordable share price after the split, a company can attract more investors, who tend to bid up the price.
  • Reverse splits signal distress, and the consolidated shares often either stagnate or fall further. Investors may see the reverse split as self-defeating by the company, unless it’s accompanied by a plan to turn around the business.

Potential advantages and disadvantages of reverse splits

A reverse split may have some potential advantages for a company. These include:

  • Maintains an exchange listing. An exchange is an essential venue for easier buying and selling of shares. If a company’s shares are delisted, trading is relegated to the over-the-counter bulletin board, or “pink sheets,” where the smallest and least liquid stocks are traded. To remain on a major exchange such as the New York Stock Exchange and Nasdaq, the shares must trade higher than $4.
  • Stays on the radar of large investors and analysts. Securities analysts and institutional investors generally avoid unlisted and so-called penny stocks, or those that trade for less than $5.
  • Can help a company spinoff plan. A company contemplating a spinoff may use a reverse split to ensure that the shares of the separated companies have high enough prices. Without a reverse split, the shares of the divided company would fall or may not qualify for an exchange listing.

At the same time, reverse splits can have some potential disadvantages:

  • A sign of weakness. Investors might see the move as evidence that the company has failed to boost shareholder value with higher earnings, so it must resort to artificially raising the share price.
  • Reduced liquidity for the stock. Fewer shares are outstanding after a reverse split, which can make trading the stock harder.
  • Encourages negative sentiment. Investors may also interpret a reverse split as a warning of further declines in the stock price.

FAQs about reverse-stock splits

Why would a company do a reverse stock split?

In most cases, a company’s primary motives are to prevent losing an exchange listing, which would make trading in the stock less liquid, and to keep fund managers and stock analysts from avoiding the stock.

What happens to my shares in a reverse split?

The number of shares will be reduced. Although the share price will rise, the value won’t change as a result of the split. Stock splits, either forward or reverse, don’t change the market value of the shares, and there is no tax consequence for investors.

Is a reverse split good or bad?

Strictly speaking, they are neither good nor bad because they don’t change the company’s current market value. But the truth is, a reverse split is often perceived by investors as an act of corporate desperation that’s little more than a gimmick to make the stock look more attractive. Instances of success after a reverse split usually are when the company also finds a new strategy or takes aggressive steps to turn around its fortunes.

The bottom line

A reverse-stock split reduces the number of shares outstanding, raises the price of each individual share but it doesn’t change the value of a company. It can be a necessary stopgap for a company that’s taking other steps to revitalize its business and boost its stock market value. Some companies have succeeded by combining a reverse split with a restructuring, such as dividing in two or spinning off struggling subsidiaries.But many companies that do a reverse split don’t have a plan beyond this bookkeeping trick. Unlike forward stock splits, which investors generally see as bullish, reverse splits are often taken as a bearish signal and may spur further selling by investors.

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