What is a ‘Reverse Stock Split’
A reverse stock split is a corporate action in which a company reduces the total number of its outstanding shares. A reverse stock split involves the company dividing its current shares by a number such as 5 or 10, which would then be called a 1-for-5 or 1-for-10 split, respectively.
A reverse stock split is also known as a stock consolidation or share rollback.
BREAKING DOWN ‘Reverse Stock Split’
A reverse stock split decreases the total number of a company’s outstanding shares and simultaneously increases the price per share. There are a number of reasons why a company may decide to reduce its number of outstanding shares in the market. In the vast majority of cases, a reverse split is undertaken to fulfill exchange listing requirements. An exchange generally specifies a minimum bid price for a stock to be listed. If the stock falls below this bid price, it risks being delisted. Exchanges temporarily suspend this minimum price requirement during uncertain times; for example, the New York Stock Exchange (NYSE) and Nasdaq suspended the minimum $1 price requirement for stocks listed during the 2008-09 bear market. However, during normal business times, a company whose stock price has declined precipitously over the years may have little choice but to undergo a reverse stock split to maintain its exchange listing.
Sometimes companies that want to inflate the prices of their stock, especially penny stocks, would do a reverse stock split to elicit negative emotions in investors towards a low stock price. Also, companies looking to create spinoffs at attractive prices may use reverse splits.
If a company has 200 million shares outstanding and the shares are trading at 20 cents each, a 1-for-10 reverse split would reduce the number of shares to 200 million / 10 = 20 million, while the shares should trade at about 20 cents x 10 = $2. Note that the company’s market capitalization pre-split and post-split should – theoretically at least – be unchanged at $40 million. At 20 cents per share, the market cap of the company was 20 cents x 200 million shares = $40 million. After the reverse stock split, the market cap remains $40 million = $2 x 20 million shares.
But in the real world, a stock that has undergone a reverse split may well come under renewed selling pressure. In the above instance, if the stock declines to a price of $1.80 after the reverse split, the company’s market cap would now be $36 million. Conversely, with a forward split, the stock may gain post-split because it is perceived as a success and its lower price might attract more investors.
A reverse stock split is the opposite of a conventional (forward) stock split, which increases the number of shares outstanding and decreases the price per share. Similar to a forward stock split, the reverse split does not add any real value to the company. But since the motivation for a reverse split is very different from that for a forward split, the stock’s price moves after a reverse and forward split may be quite divergent.
A secondary benefit of a reverse split is that by reducing the shares outstanding and share float, the stock becomes harder to borrow, making it difficult for short sellers to short the stock. The limited liquidity may also widen the bid-ask spread, which in turn deters trading and short selling.
The ratios associated with reverse splits are typically higher than those for forward splits, with some splits done on a 1-for-10, 1-for-50, or even 1-for-100.