Reverse stock splits are rare in today’s stock market in part because of their controversial nature. A reverse stock split reduces a company’s outstanding shares. It’s the opposite of a regular, or forward, stock split in which a company increases its shares.
But just like a forward stock split, a reverse split doesn’t add—or reduce—a company’s market cap or value. For example, a company with five million outstanding shares trading at $1/share has a market cap of $5 million.
If it decides to affect a 1-2 reverse stock split, that reduces the number of shares to 2.5 million. Its market cap remains the same—$5 million—so with 2.5 million shares outstanding, the share price is now $2 ($5 million divided by 2.5 million shares). Nothing changed except a reduction in the number of outstanding shares, which doubled the stock price.
However, in reality, since the motivation behind most reverse splits is generally looked at unfavorably by the investment community, these splits often immediately create downward pressure on a stock, whereas a forward split, more often than not, pushes a stock’s price higher in the near term.
Reasons for a Reverse Stock Split
So, if the market views reverse stock splits with a jaundiced eye, you may ask, why would a company decide to do such a split? The reasons are varied, and include:
1. The desire to increase the share price, especially if the shares are penny stocks. Low prices tend to elicit negative emotions in investors and inhibit the attention of the big money on Wall Street or coverage by major research firms.
2. Companies looking to create spinoffs at attractive prices may use reverse splits. Tyco International (TYC), Motorola Solutions (MSI) and Time Warner (TWX) all employed this strategy when they broke up their companies.
3. Major stock exchanges have minimum dollar amounts for the price of the stocks they list. So, to stay listed, a low-priced stock may reverse split in order to push its price to those minimums.
4. And one more reason from Thomas Rice of The Bowser Report: a reverse split may just be an attempt to extend the life of a slipping stock.
However, while the last two reasons are mostly negative, the first two can be greeted as positive strategies by investors who take their reverse splits in stride, especially if they are confident that the company is serious about a turnaround or strategy to improve its fortunes.
Reverse Split Success Stories
And there are many examples of reverse splits in which a company’s shares not only survived but prospered, including:
• Famed U.S. Government bailout candidate American International Group (AIG) was close to being yanked from the New York Stock Exchange when its stock sank below 2. The company did a 1-for-20 reverse split that sent the price above 20. Today, AIG trades at 42.
• When the recession pummeled Citigroup (C) and other financial stocks in 2011, the company executed a 1-for-10 split that boosted its shares from around 4.50 to about 45. Citigroup’s current share price is 62.
Bottom line, a reverse stock split isn’t necessarily bad. As with any announcements that affect a company’s share price, reverse splits need to be analyzed thoroughly to determine if they are simply a desperation measure or a well-thought-out maneuver to create long-term value for a company. Just be aware of the negative connotations that accompany reverse splits—fears that often send investors fleeing.
But unless you’re very sure that the split makes sense for the company, you might want to put on your running shoes.
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*This post has been updated from an original version that was published in 2017.