What Are Reverse Stock Splits, and How Do They Affect Investors?
One tactic companies use to manage their stock prices is the reverse stock split. While stock splits often bring a sense of excitement to investors, reverse stock splits can be met with uncertainty.
Let’s demystify reverse stock splits and explain what they are, why companies undertake them, and how they affect investors.
What is a Reverse Stock Split?
A reverse stock split occurs when a company reduces the number of its outstanding shares while simultaneously increasing the share price proportionately by consolidating shares into fewer higher-priced shares.1 For example, in a 1-for-10 reverse stock split, every 10 shares owned by a shareholder are consolidated into 1 share. Consequently, if a shareholder had 100 shares before the reverse split, they would own 10 shares afterward, but the total value of the shares remains the same.
Reasons for Reverse Stock Splits
There are a few reasons why companies may decide to do a reverse stock split.
Compliance with Stock Exchange Requirements
Many stock exchanges have minimum price requirements for listed stocks. For example, the New York Stock Exchange requires a minimum share price of $4.2 If a company’s stock falls below this threshold for an extended period of time, it risks being delisted. A reverse stock split can help the company meet these minimum price requirements and maintain its listing status.
Improving Perception and Attracting Investors
Stocks with very low prices can sometimes be perceived as “penny stocks,” often considered high-risk and speculative. By increasing the stock price through a reverse split, companies aim to enhance their market image, making the stock more attractive to institutional investors who may have policies against buying low-priced shares.
How Reverse Stock Splits Affect Investors
With a reverse stock split, an investor’s number of shares decreases, but the total value of their investment remains unchanged. For instance, if a stock trades at $0.50 and undergoes a 1-for-10 reverse split, the new share price would be $5. Therefore, an investor with 1,000 shares worth $500 before the split would own 100 shares worth $500 after the split.
Perceived Value and Market Reaction:
Despite this, the market can sometimes perceive reverse stock splits negatively. Investors may interpret the need for a reverse split as a sign of underlying issues within the company, such as financial instability or poor management. This perception can lead to a decline in investor confidence and potentially lower stock prices in the short term.
A reverse stock split also reduces the number of shares available for trading, impacting the stock’s liquidity. Lower liquidity can result in larger bid-ask spreads and higher volatility. Investors who need to buy or sell shares quickly may find it more challenging to do so at their desired prices.
Lastly, if the company pays dividends, a reverse stock split will also affect the number of shares on which dividends are paid. For example, if a company pays a dividend of $0.10 per share and undergoes a 1-for-10 reverse split, the new dividend payment would be adjusted to $1 per share. The total dividend received by the shareholder remains the same, but the per-share amount increases.
If investors are concerned about a reverse stock split, they shouldn’t be afraid to research the reasons behind it. Understanding whether the split is a strategic move to comply with exchange requirements, attract new investors, or address liquidity issues is crucial in assessing the company’s long-term prospects.
By understanding reverse stock splits and why companies might do them, investors can make more informed decisions and ensure that their investments align with their financial goals.
This content is developed from sources believed to be providing accurate information, and provided by LJAKE Financial Group. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
