Reverse Stock Split: What It Is and How It Works - NerdWallet (2024)

A reverse stock split occurs when a publicly traded company decides to reduce the number of shares outstanding without affecting the underlying value of the company. Management can perform a reverse stock split by combining shares together.

This may sound like a somewhat boring event - it's the equivalent of trading two $50 bills for one $100 bill. But some investors see reverse stock splits as warning signs that a company can't increase its stock price by actually improve performance.

However, when a reverse stock split is accompanied by other changes that increase value, the move can represent a welcome change in a company's strategy. Here are some factors to consider when evaluating a company in light of a reverse stock split.

Definition of Reverse Stock Split

Reverse stock splits occur when a publicly traded company intentionally divides the number of shares that investors own by a certain amount, causing the company's stock price to rise accordingly. However, this increase is not driven by positive results or changes in the company. Instead, the stock price rises because of simple math.

During a reverse stock split, the company becamemarket valuedoes not change, and neither does the total value of your shares. What changes is the number of shares you own and how much each share is worth.

If you own 50 shares of a company worth $10 per share. share, your investment is worth $500. In a 1-for-5 reverse stock split, you would instead own 10 shares (divide the number of your shares by five) and the stock price would rise to $50 per share. share (multiply the share price by five). This is the opposite of Astock split.

What immediate consequences will this change have for your investment? That's not really the case. Either way, your investment is worth $500.

Why Companies Do Reverse Stock Splits

The most obvious reason for companies to engage in reverse stock splits is to remain listed on the major exchanges. For example, if a stock on the New York Stock Exchange closes below $1 for thirty consecutive days, it can be delisted. A reverse stock split can increase the stock price enough to continue trading on the stock exchange.

But there are even more reasons. If a company's stock price is too low, investors may avoid the stock out of fear that it is a bad buy; there may be a perception that the low price reflects a company that is in trouble or unproven. To combat this problem, a company can use a reverse stock split to increase its stock price.

In either case, a reverse stock split can be a red flag for investors, but that's not always the case. Here are two basic results of a reverse stock split:

Positive.Companies that use reverse stock splits often find themselves in trouble. But if a company multiplies its reverse stock split with significant changes that improve its business, expected earnings, and other information important to investors, the higher price can hold and rise further. In this case, the reverse stock split was a success for both the company and its shareholders.

Negative.If the company were to fail to improve its business in conjunction with the reverse stock split, the stock price could continue to decline, further increasing concerns about the company's fate.

Is a reverse stock split good or bad?

If a company in yourinvestment portfolioannounces a reverse stock split, you may wonder if and how you should react before the split takes place.

In short, it is usually not a good sign.

A 2019 study that looked at 25 reverse stock splits between 2015 and 2018 found that markets punished companies after the trades. The newspaper, published inJournal of Applied Business and Economics, found that “the risk-adjusted stock price returns of the sample companies are significantly negatively affected by the reverse stock split around the announcement date.”

Steve Sosnick, chief strategist at Interactive Brokers and a former trader at Lehman Brothers and Morgan Stanley, says investors are likely to see the warning signs early.

“Presumably an investor would have noticed that the stock in question was already behaving badly, but if not, the announcement of a reverse stock split is usually another key clue,” says Sosnick.

Stock split vs. reverse stock split

The main difference between a stock split and a reverse stock split is that while a reverse stock split reduces the number of shares outstanding without affecting the total value, a conventional stock splitis increasingthe number of shares in the same way.

For example, if a company's stock is trading at $100 per share and a two-for-one stock split is executed, an investor who owns one share will end up with two shares worth $50 each.

These measures are often a response to high share prices, and they are generally viewed positively by investors.

“Just as stock splits are a sign that a company is thriving, reverse stock splits are an admission of a company that is in trouble – a big red flag,” said Robert Johnson, a financial analyst and managing director at Economic Index Associates, in an e-mail mail. interview.

Reverse stock dele examples

General Electric

General Electric provides a recent example of why reverse stock splits can spell bad news.

At the beginning of 2021, the company was struggling. In late 2010 and early 2020, it had sold off some of its most recognizable businesses, such as electric lighting. The stock price was also down more than 50% from its 2016 high.

On May 4, 2021, General Electric's board of directors announced a 1-for-8 reverse stock split. The company described it as a sensible share reduction, commensurate with the reduction in business volume.

But the shareholders did not see it that way. The reverse split became effective on June 30, 2021, and the following year the company's market cap fell another 40% (although GE shares recovered slightly in 2023).

Shareholders saw a higher share price as a result of the reverse split – but they also saw a reduction in the number of shares they owned, meaning they didn't make any extra money. And over the next twelve months, they lost a significant portion of that money.

Citigroep

In 2011, the company underwent a 1-for-10 reverse stock split (and also reinstated the dividend), causing its shares to rise from about $4, which is technically considered acent stock, for more than $40. Although the stock price has risen since then, it never entered penny stock territory again.

The split came after Citigroup reported in 2010 the first year of four profitable quarters since 2006, highlighting an important consideration: If a company improves its earnings and cash flow and commits to further improvements in the future, a reverse stock split can may not be the case. mean disaster. But that may be the exception, not the rule.