What is a reverse split?
May 26, 2022 10:37 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.
What’s in this guide:
- What is a reverse split?
- Are reverse splits good for investors?
- How to profit from reverse stock splits
- Reverse split stocks
What is a reverse stock split?
A reverse stock split is a type of corporate action that aims to reduce a company’s overall number of shares available on the market. The process works as the exact opposite of a standard stock split: instead of splitting out shares, it involves merging them together.
In a 1-for-2 reverse stock split, for example, investors will see their holdings cut in half. However, the share price will then adjust accordingly, which keeps the total value of the shares – and the company’s market cap – at the same level.
While reverse splits shouldn’t affect market caps directly, the fallout from them can see demand for a stock rise or fall, which will in turn raise or lower the company’s share price and value.
As well as 1-for-2 reverse splits (1:2), 1-for-4, 1-for-8 or even higher are common. You’ll often hear reverse stock splits referred to as share consolidations or mergers.
Let’s take a closer look to see how reverse splits work in practice.
Reverse split example
You currently own 100 shares of XYZ Company at $10 per share, a total investment of $1,000. XZY Company has 1,000,000 shares outstanding, giving it a market cap of $10,000,000. It announces a 1:2 reverse stock split.
Every two shares owned by shareholders will get converted to one share once the reverse stock split is complete. The reverse stock split affects your investment in XYZ Company in the following ways:
- After the 1:2 reverse stock split, there are now 500,000 shares outstanding
- The market capitalisation is not affected by a reverse stock split. The 500,000 shares now outstanding must still achieve a total market capitalisation of $10,000,000
- Each share is now worth $20
- You now own 50 shares in XYZ Company instead of your previous 100
- Each share is now worth $20 instead of the previous $10, so your investment in XZY Company remains unchanged
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Are reverse splits good for investors?
There is one chief reason why a company may choose to undertake a reverse stock split: to raise its share price. While the firm’s market cap should remain unaffected by the drop in share supply, the individual price of each share may change drastically.
The 1:2 share consolidation example above saw the company’s share price double. A 1:4 merge, on the other hand, will see it quadruple. Reverse splits of 1:100 aren’t unheard of.
Again, the action here is the opposite of what you’ll see in a standard stock split. Whereas a split lowers the share price by creating more stock, a reverse split raises it by reducing the number of shares available.
But why would a company want to take direct action to raise its share price, without affecting its overall value? There are several reasons – let’s take a look at a few common ones.
1. To prevent delisting
Some stock exchanges have minimum price rules, which mean that a company is at risk of having its stock delisted if it falls beneath a certain price. 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
Hedge funds and wealthy institutional investors use options to invest and hedge – but like stock exchanges, many options markets require minimum share prices. 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, for example, it might get tagged as a penny stock – a term that can have a negative stigma and drive investors away. The reverse split might give the firm’s brand a boost and attract more investors.
Is a share consolidation good for investors?
A share consolidation can be good for investors, but not always. More often than not, they’re taken as a sign that a company’s stock is struggling – which can only add to the firm’s woes.
Returning to our list of possible reasons for a consolidation above, most of them are defensive actions taken by a firm’s board. Contrast that with standard stock splits, which are generally used to keep a runaway share price in check, and you can see why consolidations are often treated with caution by the markets.
Because of this, stock mergers are rarely undertaken lightly by a company’s board, who will weigh up the potential investor backlash before proceeding. Occasionally, they’ll offer an explanation that clears any doubts about the long-term future of the company – in these instances, mergers can be good news for shareholders and traders.
As with any corporate action, it’s worth taking a step back, doing a little bit more research and deciding the best approach when confronted with a reverse split.
How to profit from reverse stock splits
To profit from a reverse stock split, you’ll first need to decide how the company’s share price might move after the action is complete. Then, you can open your position accordingly via your stockbroker or trading provider.
Generally, there are two possible outcomes from a share consolidation:
- The markets see that the corporate action is part of a wider plan and respond well. Demand increases for the company’s stock, and its price rises
- The markets are spooked by the reverse stock split, seeing it as a sign of bad times for the business. Demand falls and the share price follows
As you can see, this boils down to two simple moves: either the price goes up, or it goes down.
With traditional investing, profiting from downward price action via short selling can be a tricky process. You’ll need to borrow stock, then sell it on and buy it back. So many traditional investors choose to only focus on shares with an upward trajectory.
Derivatives such as CFDs enable you to go short as well as long. If you’ve found a company that’s planning a potentially risky reverse split, you can see it to profit from the downward move – although you’ll make a loss if it rises.
One key point to bear in mind, though, is that often the major price action around a consolidation occurs when the corporate action is announced. By the time of the merger itself, the markets may have factored it in resulting in low volatility.
Reverse split stocks
Here are two examples of notable stocks that have completed reverse splits.
General Electric (GE)
Blue-chip stocks don’t tend to go in for reverse splits, which made GE’s announcement that it was undergoing a 1:8 consolidation in August 2021 all the more surprising.
In GE’s case, the reason for the split wasn’t so much avoiding a delisting as achieving a share price comparable to its peers, after several years of waning performance. It saw the firm’s shares jump from below $15 to above $100 – but failed to kickstart a bull run, with a price slightly lower by the end of the year.
Naked Brands (NAKD)
In December 2021, Naked Brands completed a 1:15 reverse split that saw its stock price leap from less than 50 cents up above $7. Again, the aim wasn’t avoiding a delisting – instead, NAKD wanted to inflate its stock ahead of its acquisition of Cenntro Automotive, an EV manufacturer.
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