The number of stocks a company has isn’t fixed. The stock count may increase if a company splits each of its stocks into two or more. It may also decrease if the company consolidates two or more stocks into one stock.
These two events are known as a stock split and a reverse stock split. Companies may use stock splits and reverse stock splits for a variety of reasons. But although a stock split may seem straightforward because it increases the number of stocks available in the market, how does a reverse stock split work? And why do companies use it?
Let’s explore what a reverse stock split is and how it may affect your investments if your stocks were subject to it.
What is a reverse stock split?
If you’re investing money in stocks, you might encounter a reverse stock split. This is an event when a company reduces the number of outstanding shares.
It would achieve this reduction by converting existing stocks into fewer stocks at a higher price. For example, it could cut the number of shares it has in half while doubling the company’s share price at the same time.
In this example, you might have had 10 shares priced at $100 per share before the reverse stock split. After the split, you have five shares priced at $200 per share. The ratio in this example is 1-2, but keep in mind that reverse stock splits could happen in any ratio, such as 1-4 or 1-10.
Stock splits and reverse stock splits themselves don’t directly change the value of a company. The total company value remains the same, and the number of stocks and price of each stock change to add up to the same value before and after a split event. That’s why reverse stock splits increase the stock price without changing the company value.
The indirect effect of reverse stock splits
Although a reverse stock split doesn’t change a company’s value directly, it may do so indirectly. For example, a higher stock price may increase the perceived value of a company.
Consider penny stocks that are generally priced at $5 or lower. These stocks are often viewed as a highly risky asset class that might not offer many opportunities. With a reverse stock split, a company could use this consolidation to push its stock price over that threshold, which may change how investors view the stock.
Forced reverse stock split cash out
The reduction in outstanding stocks may lead some stockholders to be cashed out of the stock after a reverse split. For instance, suppose an investor owns 10 stocks, and a company performs a 1-for-20 reverse stock split. In this case, the investor would be left with half a share.
Owning half a share might not be an issue on some of the best investment apps because some apps may allow you to hold fractional shares.
WarningAn investor may receive cash after a reverse split if their broker or investment platform doesn’t support fractional shares and only allows them to hold whole shares.
How does a reverse stock split work?
When a company performs a reverse stock split, it reduces the number of stocks in the market without any impact on its value.
For instance, imagine a company with 1 million outstanding stocks priced at $3 each. The company’s total value or market capitalization would be $3 million.
However, the company might not be satisfied with its current stock price because it’s considered a penny stock. At that price, the company also finds itself unable to be listed on the New York Stock Exchange (NYSE) because there is a stock price requirement of at least $4 to be listed.
The company may then decide to perform a 1-for-10 reverse stock split, reducing its stock count to 100,000 while raising the price of each company’s stock to $30. The company’s market cap remains unchanged at $3 million.
Reverse stock split vs. stock split
A reverse stock split is when a company combines its existing shares into fewer shares. A stock split is the opposite because it splits outstanding shares into a larger number of lower-priced shares.
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Fidelity maintains a list of stock splits that it updates periodically. The list includes reverse stock splits and stock splits. The easiest way to tell the difference is that reverse stock splits have a smaller number first in the split ratio, for example, 1-5. Stock splits have a larger number first, such as 5-1. Another notable difference is that a reverse stock split increases a company’s stock price whereas a stock split decreases it.
A company may perform a reverse stock split to increase its stock price due to a falling stock price. On the other hand, a company may initiate a stock split when its stock price has risen so much that many investors could no longer afford them. A stock split reduces the stock price, making the stock more accessible to investors.
Example of a reverse stock split
One of the recent reverse stock splits was performed by CASI Pharmaceuticals (CASI), a biotech company that announced a 1-for-10 reverse stock split.
The CASI reverse split went into effect on June 2, 2022. CASI traded at 40 cents per share at the stock market close on June 1, 2022. A 1-for-10 reverse split would have the stock trading around $4.00 after the split. By market closing time on June 2, the stock market value had dropped to $3.71.
Example of a stock split
One of the most notable stock splits announced in 2022 was a 20-for-1 split announced by Amazon (AMZN).
The split went into effect on May 27, 2022, and reduced Amazon's share price from more than $2,000 to about $120 per share. Investors who held their shares through the split now have 20 times the shares at the lower price.
3 advantages of a reverse stock split
Reverse stock splits may have some advantages for a company, especially if it isn’t satisfied with its share price. These advantages include:
- Increasing the company’s stock price: The immediate benefit of a reverse stock split is that it could increase a company’s stock price. A low stock price may cause investors to lose confidence in the company. A reverse stock split may help the company earn investor confidence once again.
- Qualifying to be listed on an exchange: Some stock exchanges, such as the NYSE, have stock price thresholds that companies must meet to be listed on the exchange. A reverse stock split could help a company meet those requirements — or avoid delisting if its stock price declines.
- Attracting analyst attention: Analysts tend to focus on stocks with higher stock prices, perhaps partly because penny stocks may be seen as questionable investment opportunities. A reverse stock split and the resulting price increase may get the company more attention. This may further increase investor interest or confidence.
What are the disadvantages of a reverse stock split?
Reverse stock splits could also be problematic. Here are the biggest disadvantages:
- Harming investor confidence: Although companies may complete a reverse stock split to boost investor sentiment, it could backfire and have the opposite effect. This is because investors may see the reverse split as an attempt to artificially prop up the stock price and a sign that the company is struggling.
- Dropping the stock price: If investors lose confidence in a company after a reverse split, they might decide to sell some of their stocks. This would lead the stock price to decrease.
FAQs about reverse stock splits
Can you make money from a reverse stock split?
A reverse stock split wouldn’t directly make you money. However, you might make money on a reverse split if it increases investor confidence and boosts interest in the stock. Reverse stock splits may also have the opposite effect, causing investors to lose confidence and sell their stocks.
Do you lose money after a reverse stock split?
A reverse stock split doesn’t directly reduce your investment value. However, you may lose money after a reverse stock split if it signals that the company is struggling or trying to push its stock price higher. Investors might lose confidence in the company and decide to sell their stocks, causing a price drop.
Who benefits from reverse stock splits?
Generally, a reverse stock split benefits the company performing the split. Reverse splits typically happen in response to declining stock prices as a company looks to boost investor confidence. However, a reverse split could benefit both companies and investors, for example, if it helps the company avoid getting delisted from a major exchange such as the NYSE or NASDAQ.
Are reverse stock splits good or bad?
A reverse stock split is not inherently good or bad. The board of directors of a company may see its stock prices declining and decide to perform a reverse split to boost its stock price. This could attract new investors and increase interest from analysts. However, it could also lead to a decline in the stock price as investors may see a reverse split as a sign of problems within the company.
A reverse stock split involves reducing the number of outstanding stocks a company has in exchange for an increase in the stock price.
The value of the company is not directly affected by the reverse split, but reverse splits often happen in response to declining stock prices as companies look to boost investor confidence. In some situations, reverse splits may achieve the desired boosted confidence. Still, in other situations, they could have the opposite effect as investors may see them as signs of financial health issues.
Understanding how investing works could be the key to better management of your assets. Continue expanding your knowledge about getting started in the stock market and how to invest in stocks online.
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