What is a reverse split?
FOREX.com May 10, 2021 9:35 AM
A reverse split is the process whereby a listed company reduces the amount of its tradable stock. If you’re an investor or stock trader, it’s essential to know what’s involved and how a share price can be affected. Read on to find out more.
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- What is a reverse split?
- Why does a firm have a reverse stock split?
- Is a reverse stock split good for investors?
- A reverse split calculation and example
- How to find reverse stock splits
What is a reverse stock split?
A reverse stock split is an action by a listed firm that reduces the total number of shares into fewer, more valuable shares. A reverse stock split is also called a stock or share consolidation, or stock merge.
The process is the opposite of a stock split, where a share gets divided into multiple parts, thereby increasing the tradeable shares.
Neither a reverse stock split nor a stock split directly changes the overall market capitalisation, although it might change later depending on how the market reacts to the news and the result of the stock split.
Here’s a quick example of how the reverse split works in practice.
Suppose you own 200 shares at $50, and the company does a 1-for-2 reverse stock split. You now own 100 shares at $100. The reverse stock split slices the pie into 5 portions instead of 10.
There is no accepted standard or formula for a reverse stock split ratio; the ratio chosen depends on the share price the company wants its shares to trade at on the market.
Why does a firm have a reverse stock split?
There might be several reasons why a firm might execute a reverse stock split; here are a few.
1. To prevent a delisting of the stock
If a stock price falls below a specific price, the firm and shares risk becoming delisted from a stock exchange with minimum share price rules. A reverse stock split should boost the share price to avoid this.
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2. To increase market attention
Analysts and investors might take an interest in a firm that organises a reverse stock split. The company might have undergone wholesale management changes, resulting in a new direction and ambition.
Higher-priced stocks typically attract more attention from market analysts, and any changes such as a reverse stock split will get analysts’ attention.
3. To remain on options exchanges
Suppose a company’s stock price falls too low for options trading on it. In that case, hedge funds and wealthy institutional investors who invest billions of dollars in the market and hedge positions through the options market might lose interest. If fund managers can’t hedge their long positions, they could sell the stock due to delisting from an options exchange.
4. To boost public relations
A stock with a low share price can be considered risky. If it falls below a dollar, it might get tagged as a penny stock. Such a term can be a negative stigma and drive investors away. The reverse split might give the firm’s brand a boost and attract more investors.
Is a reverse stock split good for investors?
Not always. A reverse stock split can broadcast a negative signal to the market, unlike a stock split which is considered a positive action.
A company is more likely to undertake a reverse stock split if the share price falls so low it’s in danger of being delisted. Investors might think the company is struggling and view the reverse split as an act of desperation or accountancy trick.
Company directors usually consider the potential negative impact before engaging in reverse stock splits. The management must think of any benefits of the reverse stock split and whether they might outweigh the risk of negative investor sentiment.
Whether a reverse stock split is good for investors also depends on the company’s explanation for the action. Investors will examine why and want to ensure the measure improves the firm’s standing and financial position.
A reverse stock split typically sets alarm bells ringing. If a company is trying to boost its share price to attract new investors, it could be a red flag and market signal that it’s desperate for cash.
Some other indications that a company is struggling include a disappointing earnings report or a cancelled dividend. There are two usual outcomes after a company engages in a reverse stock split.
New opportunities get created for the company to grow and strengthen financially. But the split by itself can’t ensure this. Investors and analysts will need to see other measures getting taken to shore up the company.
For instance, if the company is aggressively looking to cut its debt pile and expand into new markets with new products and services to increase its earnings, the reverse stock split could deliver long-term benefits.
Alternatively, if the stock price falls after the reverse stock split, the investor’s new combined shares lose value. This scenario often plays out if the market concludes the firm isn’t making other efforts to improve its financial situation.
Reverse splits aren’t uncommon, and a sceptical market tends to view them as tactical rather than entrepreneurial.
When a reverse stock split gets announced, the decision to hold or sell hinges on the reason for the reverse split.
If a reverse stock split is to raise the stock price and attract new investors, it’s essential to consider the firm’s overall plan. Analysis of the finances, while examining metrics such as price to earnings (P/E) ratio, earnings per share (EPS) and other vital health factors, can give you a better idea of the company’s future direction and current performance.
Reverse split calculation and example
You currently own 100 shares of XYZ Company at $10 per share, a total value of $1000. XZY Company has 100,000 shares outstanding and announces a 100:1 reverse stock split.
Every 100 shares owned by shareholders will get converted to 1 share once the reverse stock split is complete.
The reverse stock split affects your investment in XYZ Company in the following ways:
- With 100,000 shares outstanding and a share price of $10, the market capitalisation of XYZ Company is still $1,000,000
- After the 100:1 reverse stock split, there are now 100 shares outstanding post-split
- The market capitalisation is not affected by a reverse stock split. The 100 shares now outstanding must still achieve a total market capitalisation of $1,000,000
- Each share is now worth $1000
- You now own 1 share in XYZ Company instead of your previous 100
- Each share is now worth $1000 instead of the previous $10, so your investment in XZY Company remains unchanged
How to find reverse stock splits
To find out about reverse stock splits – or any kind of corporate action – you’ll need to read the latest news and analysis on your chosen company. You can find up-to-date information from our in-house team here.
You can profit from a reverse stock split by correctly predicting whether the share price will rise or fall in value after the corporate action. Ready to trade shares? Open an account today or practise trading on a demo account.
Reverse splits in summary
A reverse stock split will automatically reduce the number of shares each shareholder owns into fewer, more valuable shares.
A reverse stock split can warn investors that a company is in financial trouble because the stock split can boost the price of previously low-value shares.
Reverse splits often occur to prevent the company’s shares or options from getting delisted from exchanges, and the stock split can also improve market sentiment.
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