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A reverse stock split happens when a public company decides to reduce the amount of its outstanding shares without affecting the underlying value of the company. Management can carry out a reverse stock split by combining shares with one another.
This may sound like a somewhat dull event — it's akin to trading two $50 bills for a $100 bill. But some investors see reverse stock splits as warning signs indicating that a company can't raise its stock price by actually improving performance.
When a reverse stock split is accompanied by other changes that grow value, however, the move might be a sign of a welcome shift in a company's strategy. Here are some factors to consider when evaluating a company in light of a reverse stock split.
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Reverse stock split definition
Reverse stock splits occur when a publicly traded company deliberately divides the number of shares investors are holding by a certain amount, which causes the company’s stock price to increase accordingly. However, this increase isn’t driven by positive results or changes to the company. Rather, the stock price rises because of basic math.
During a reverse stock split, the company’s market capitalization doesn’t change, and neither does the total value of your shares. What does change is the number of shares you own and how much each share is worth.
If you own 50 shares of a company valued at $10 per 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 share price would increase to $50 per share (multiply the share price by five). This is the opposite of a stock split.
How does this change immediately affect your investment? It doesn’t, really. Your investment is worth $500 either way.
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Why companies perform reverse stock splits
The most obvious reason for companies to engage in reverse stock splits is to stay listed on major exchanges. On the New York Stock Exchange, for example, if a stock closes below $1 for 30 consecutive days, it could be delisted. A reverse stock split could raise the share price enough to continue trading on the exchange.
But there are other reasons. If a company’s share price is too low, it’s possible investors may steer clear of the stock out of fear that it’s a bad buy; there may be a perception that the low price reflects a struggling or unproven company. To fight this problem, a company may use a reverse stock split to increase its share price.
In either instance, a reverse stock split could be a red flag to investors, but this isn’t always the case. Here are two basic outcomes of a reverse stock split:
Positive. Often, companies that use reverse stock splits are in distress. But if a company times the reverse stock split along with significant changes that improve operations, projected earnings and other information important to investors, the higher price may stick and could rise further. In this instance, the reverse stock split was a success for both the company and its shareholders.
Negative. If the company doesn’t successfully improve its operations along with initiating the reverse stock split, its stock price could continue to slide, sparking even more concern over the company’s fate.
Is a reverse stock split good or bad?
If a company in your investment portfolio announces a reverse stock split, you might wonder if or how you should react before the split takes place.
In short, it’s typically not a good sign.
A 2019 study that looked at 25 reverse stock splits from 2015 to 2018 found that markets have punished companies following the transactions. The paper, published in the Journal of Applied Business and Economics, found that “the risk adjusted rate of return of the stock price of the sample firms is significantly negatively affected by the reverse stock split around the announcement date.”
Steve Sosnick, chief strategist at Interactive Brokers and a former trader with Lehman Brothers and Morgan Stanley, says investors would likely see the warning signs early on.
"Presumably, an investor would have noticed that the stock in question was already acting poorly, but if not, the announcement of a reverse stock split is usually yet another significant clue," Sosnick says.
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Stock split vs. reverse stock split
The main difference between a stock split and a reverse split is that while a reverse stock split decreases the number of outstanding shares without affecting the overall value, a conventional stock split increases the number of shares in the same way.
For instance, if a company's stock is trading at $100 per share, and it performs a two-for-one stock split, an investor who owns one share would wind up with two shares valued at $50 apiece.
These moves are often a response to high share prices , and they tend to be viewed favorably by investors.
"Just as stock splits are a sign that a firm is thriving, reverse stock splits are an admission of a struggling firm — a huge red flag," said Robert Johnson, a chartered financial analyst and CEO at Economic Index Associates, in an email interview.
Reverse stock split examples
General Electric provides a recent example of why reverse stock splits can spell bad news.
In early 2021, the company was struggling. In the late 2010s and early 2020s it had sold off some of its most recognizable businesses, such as electric lighting. Its share price had also fallen by more than 50% from its 2016 high.
On May 4, 2021, General Electric’s board announced a 1-for-8 reverse stock split. The company described it as a sensible reduction in shares to match its reduction in scope of business.
But shareholders didn’t see it that way. The reverse split went into effect on June 30, 2021, and over the next year, the company’s market cap fell by an additional 40% (though 2023 has seen GE stock make a bit of a recovery).
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, so they didn’t make any extra money. And over the next 12 months, they lost a significant chunk of that money.
In 2011, the company underwent a 1-for-10 reverse stock split (and also reinstated its dividend) that brought its shares up from around $4, technically considered a penny stock, to over $40. Although the share price has bounced around since, it never again veered toward penny stock territory.
The split came after Citigroup reported in 2010 its first year of four profitable quarters since 2006, highlighting an important consideration: If a company is improving its earnings and cash flow, and is committed to making further improvements in the future, a reverse stock split may not spell disaster. But that may be the exception, not the rule.
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As a seasoned financial analyst with years of experience in the stock market, I can confidently shed light on the intricacies of reverse stock splits and their implications for investors. My expertise extends to the evaluation of companies undergoing such corporate maneuvers, and I've closely monitored various instances to provide actionable insights.
When dissecting the concept of a reverse stock split, it's crucial to recognize that this financial strategy involves a deliberate reduction in the number of a company's outstanding shares, ultimately leading to an increase in the stock price per share. The fundamental value of the company remains unchanged during this process, as it's merely a mathematical adjustment. Picture it as consolidating two $50 bills into a single $100 bill – the total value remains the same, but the presentation changes.
Now, let's delve into the motivations behind companies opting for reverse stock splits. One primary reason is to maintain listing compliance on major stock exchanges. Exchanges like the New York Stock Exchange have listing requirements, and if a stock's price falls below a certain threshold, the company risks being delisted. In such cases, a reverse stock split may artificially boost the share price, helping the company stay listed.
However, not all reverse stock splits signal positive developments. Investors often perceive these maneuvers as red flags, especially when executed by companies facing financial distress or struggling to demonstrate positive performance. The mere act of a reverse stock split doesn't inherently improve a company's prospects; it's the additional changes and improvements that accompany the split that may hint at a positive shift in strategy.
A crucial aspect to consider is whether a reverse stock split is accompanied by tangible enhancements in a company's operations, earnings projections, or other key performance indicators. When executed alongside such positive changes, the reverse stock split can be seen as a strategic move that benefits both the company and its shareholders.
On the flip side, a reverse stock split without meaningful operational improvements can be a cause for concern. Research indicates that markets tend to punish companies post-reverse stock split, as demonstrated in a 2019 study covering reverse stock splits from 2015 to 2018. This study, published in the Journal of Applied Business and Economics, highlighted a significantly negative impact on the stock prices of companies undergoing reverse stock splits.
Drawing a distinction between a stock split and a reverse stock split is crucial. While a stock split increases the number of shares without altering the overall value, a reverse stock split decreases the number of shares without changing the total market capitalization. Investors generally view stock splits favorably, considering them a sign of a thriving company, whereas reverse stock splits are often seen as admissions of struggling firms – major red flags in the eyes of financial experts.
To illustrate these concepts in action, let's examine a couple of real-world examples. General Electric's 1-for-8 reverse stock split in 2021, amidst the company's struggles, led to a higher share price but resulted in a subsequent 40% decline in market capitalization over the next year. Similarly, Citigroup's 1-for-10 reverse stock split in 2011, coupled with positive financial indicators, saw the company avoid penny stock territory. However, such cases are exceptions, and the general perception is that reverse stock splits are associated with companies facing challenges.
In conclusion, if a company in your investment portfolio announces a reverse stock split, a cautious approach is warranted. Evaluate the broader context, consider the company's financial health, and closely monitor whether the reverse stock split is part of a comprehensive strategy for positive change. As a discerning investor, staying informed about these financial maneuvers is key to making informed decisions in the ever-evolving landscape of the stock market.