What is a reverse stock split?

Reverse stock splits occur when a publicly traded company divides the number of shares investors own by a specific amount, causing the company's stock price to rise accordingly. This increase, however, is not being driven by positive company results or changes. Rather, the stock price rises due to simple math.

The company's market capitalization remains unchanged during a reverse stock split, as does the total value of your shares. What does change is the number of shares you own and the value of each share. Your investment is worth $500 if you own 50 shares of a company worth $10 per share. In a 1-for-5 reverse stock split, you would own 10 shares (divide your share count by five), and the share price would rise to $50 per share (multiply the share price by five). A stock split is the inverse of this.

How will this change affect your investment right away? It really doesn't. In either case, your investment is worth $500.

Citigroup reverse split its shares one-for-ten in May 2011 in an effort to reduce share volatility and discourage speculator trading. The reverse split raised the share price from $4.52 to $45.12 after the split. Each investor's ten shares were replaced with one share. Despite the fact that the split reduced the number of outstanding shares from 29 billion to 2.9 billion, the company's market capitalization remained constant (around $131 billion).

Why companies perform reverse stock splits?

The most obvious reason for companies to use reverse stock splits is to maintain their listing on major exchanges. If a stock closes below $1 for 30 days in a row on the New York Stock Exchange, it may be delisted. A reverse stock split could raise the share price sufficiently to keep the stock trading on the exchange.

However, there are other reasons. If a company's share price is too low, investors may avoid the stock for fear of making a bad investment; there may be a perception that the low price reflects a struggling or unproven company. To combat this issue, a company may use a reverse stock split to raise the share price.

How does a reverse split affect short sellers?

Stock splits have no significant impact on short sellers. Some changes occur as a result of a split that can have an impact on the short position. They have no effect on the value of the short position. The number of shares shorted and the price per share are the two most important changes in the portfolio.

The final word on reverse stock splits

A reverse stock split increases a company's share price by reducing the number of shares each investor owns — without changing the company's actual market value. It's a strategy frequently employed by distressed companies, some of which are attempting to avoid delisting. According to studies, it can be an omen of poor performance in the future.

There are, of course, outliers. Citigroup is frequently used as an example: in 2011, the company underwent a 1-for-10 reverse stock split (and also reinstated its dividend), bringing its shares from around $4, technically considered a penny stock, to more than $40. Although the share price has fluctuated since, it has never returned to penny stock territory.

Positives

Companies that use reverse stock splits are frequently in trouble. However, if a company combines the reverse stock split with significant changes that improve operations, projected earnings, and other information important to investors, the higher price may persist and rise further. The reverse stock split was a success for both the company and its shareholders in this case.

Attract large investors

Companies can maintain higher share prices through reverse stock splits because many institutional investors and mutual funds have policies prohibiting them from investing in a stock whose price is less than a certain threshold. Even if a company avoids the exchange's delisting risk, its failure to qualify for purchase by such large-sized investors harms its trading liquidity and reputation.

Please regulators

The number of shareholders, among other factors, determines a company's regulation in various jurisdictions around the world. Companies may reduce the number of shares issued in order to reduce the number of shareholders subject to the jurisdiction of their preferred regulator or set of laws. Companies seeking to go private may also use such measures to reduce the number of shareholders.

Negatives

If the company fails to improve its operations while also initiating the reverse stock split, its stock price may continue to fall, raising even more concerns about the company's fate.

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