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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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I am a seasoned financial expert with a deep understanding of stock markets, corporate finance, and investment strategies. My background includes years of experience in analyzing financial markets, assessing the performance of various companies, and interpreting market trends. I have closely followed the dynamics of stock splits, reverse stock splits, and their implications on company valuations.
Now, let's delve into the key concepts mentioned in the article:
1. Reverse Stock Split Definition:
- A reverse stock split occurs when a public company intentionally reduces its outstanding shares, leading to an increase in the stock price.
- This action is performed by combining existing shares, resulting in a higher share price without altering the company's market capitalization.
2. Reasons for Reverse Stock Splits:
- The primary motive is often to maintain listing on major exchanges. Exchanges like the New York Stock Exchange may delist a stock if it consistently trades below a certain price (e.g., $1).
- Low stock prices can deter investors, who may perceive it as a sign of a struggling or unproven company. A reverse stock split aims to increase the share price to attract investors.
3. Positive and Negative Outcomes of Reverse Stock Splits:
- Positive outcomes occur when the reverse stock split is accompanied by significant positive changes in the company's operations, earnings, and overall performance.
- Negative outcomes arise when the company fails to improve its fundamentals along with the reverse stock split, leading to continued stock price decline.
4. Impact on Investors:
- A reverse stock split does not immediately affect the value of an investor's holdings. The total investment value remains the same; only the number of shares and the share price change.
- Investors may view reverse stock splits as potential red flags, especially if not accompanied by positive operational changes.
5. Stock Split vs. Reverse Stock Split:
- The main distinction lies in the effect on the number of outstanding shares. A stock split increases shares while maintaining overall value, whereas a reverse stock split decreases shares without changing the overall value.
6. Examples of Reverse Stock Splits:
- General Electric (GE): In 2021, GE underwent a 1-for-8 reverse stock split amid struggles. Despite a higher share price, shareholders experienced a significant market cap decline.
- Citigroup: In 2011, Citigroup executed a 1-for-10 reverse stock split after reporting profitable quarters. While the share price increased, its long-term success was an exception rather than the rule.
7. Expert Commentary:
- The article quotes Steve Sosnick, chief strategist at Interactive Brokers, who emphasizes that a reverse stock split is often a significant clue of a company's poor performance. Investors should be vigilant and consider it a warning sign.
In summary, reverse stock splits are complex financial maneuvers with potential implications for investors. Understanding the reasons behind them, evaluating associated changes, and considering historical examples can aid investors in making informed decisions.