A reverse stock split, also known as a stock consolidation, stock merge, or share rollback, is when a company combines several existing shares into fewer (but higher-priced) shares. It’s the opposite of a forward stock split, which divides a single share into multiple, lower-priced shares. Join us for a breakdown of reverse stock splits, why they happen, and what you need to know as an investor.
When a company announces a reverse stock split, they plan to consolidate their stock into fewer shares that will trade for a higher price. For instance, if a company announces that they’re going to do a 1-for-5 (or 1:5) reverse split, it means that for every five shares you currently own in the company, you’ll now own one share or the same combined value.
Say, for instance, that you currently own five shares of company XYZ, each of which is worth $5 apiece. After the 1:5 reverse split, you’d own one share of XYZ that was worth $25.
As you can see, this doesn’t actually change the value of your holdings in the company, as the price of each of the original five shares is simply rolled into one. Reverse split ratios can differ and largely depend on the price the company would like to trade. Common reverse swap ratios are 1:2, 1:5, 1:10, 1:50, or even 1:100.
Common Questions About Reverse Stock Splits
What happens to leftover shares after a reverse stock split? This is a common question that investors ask, especially if the number of shares they currently own doesn’t make for an even swap ratio. For example, say that you currently own 25 shares of company ABC, which has just announced an impending 1:2 reverse split. Will you be left with 12.5 shares?
Generally, a reverse split does not tend to result in fractional shares, as the company will usually do one of two things. Occasionally, they will round an investor’s uneven number of shares up to the nearest whole number, which in this example would result in 25 shares becoming 13.
More commonly, they’ll pay out cash for any leftover share fractions. If this were the case, you’d end up with 12 shares after the split and receive a payout for the remaining half share.
Another common question is, how does a reverse stock split affect dividend payouts? Much like the value of the shares themselves, dividends are simply consolidated at the reverse split ratio. So if you have 5 shares that each paid out a $.25 dividend before a 1:5 split, your resulting single share would pay out a $1.25 dividend.
Reasons for Reverse Stock Splits
Unlike a forward stock split, a reverse stock split is generally perceived as an unflattering indication of how a company is doing. So why would a company even consider it? There are several reasons a company might choose to make such a move, including the following:
- To Avoid Getting Delisted
Major exchanges such as the NYSE and NASDAQ have certain requirements that companies must meet to get and stay listed on their exchanges. If a company fails to meet these requirements over a certain period of time, they risk being kicked off of the exchange or “delisted.” If a company is struggling to maintain these requirements, a reverse stock split may give them the boost they need to remain listed.
- To Make the Company Appear More Legitimate
Even if the company isn’t in immediate danger of delisting, it may be trading in or around the penny stock zone. Penny stocks are stocks that are currently trading for less than $5 and tend to be avoided by large institutional investors. Unfortunately for the company, institutional support is usually a necessary component of major price movement. A reverse split may be an attempt on the company’s part to garner more interest among analysts and major market movers.
- A Shaky Financial Outlook
If a company is anticipating an unflattering earnings report due to financial difficulties, then a reverse stock split can serve to provide a little extra padding. By raising the price of each share, the stock’s price has more room to fall without entering into penny stock or delisting territory.
Each of the above reasons for performing a reverse stock split comes with a list of pros and cons. On the one hand, a company may succeed in remaining on a major exchange or avoid dropping beneath the threshold at which institutional investors tend to lose interest. On the other hand, it’s generally pretty obvious what they’re doing and is considered a self-defeating move by many analysts. Reverse splits under these circumstances can be a turn-off for potential investors and make current shareholders nervous.
More Positive Reasons for Reverse Stock Splits
A reverse stock split isn’t always necessarily a bad sign and, depending on the situation, may even be a sound move on the company’s behalf. Here are some examples of situations in which a reverse stock split makes sense.
- Mergers and Acquisitions
When a company acquires or merges with a new company, it’s a common move for them to merge the acquired company’s shares with their own. However, a potential problem may arise if this results in more shares than the company’s articles of incorporation allow. In this case, the company would simply consolidate the acquired company’s shares through a reverse stock split to merge them with their own. The acquired company’s shareholders would then have their old shares replaced with shares of equal value in the acquiring company.
- Lowering the Float for Large Investors
A reverse split can reduce the total number of shares that a company offers on the market substantially. This can be attractive for an investor who is seriously interested in owning a large portion of the company, as it requires them to purchase a smaller number of shares to do so. A reverse split also decreases transaction costs for large, institutional investors who tend to buy shares in bulk. As the number of shares outstanding is reduced, the stock’s earnings-per-share or EPS begin to rise, which can, in turn, help the price of each share rise as well.
A company may perform a reverse stock split for several reasons, and, as an investor, it’s important to find out exactly what inspired them to do so. The company’s reasoning should tell you a great deal about whether the reverse split represents a cause for concern or whether it may actually work to the benefit of shareholders.
