Reverse Stock SplitWhere multiple shares of stock are merged to leave investors with fewer shares of more valuable stock

Written By:
Lisa Borga

Reviewed By:
FundsNet Staff

A reverse stock split, also known as a reverse split, or a stock merge, is a process in which a company reduces the existing number of stock shares by merging them into a smaller number of proportionally more valuable shares.

This is typically performed by dividing the current number of shares by the split ratio, such as one new share for five old shares.

A reverse split is the exact opposite of an ordinary stock split or forward split.

Unlike a reverse stock split, a forward split divides existing shares into a greater number of proportionally less valuable shares.

Because reverse stock splits are often associated with the idea that share prices are suffering, this restructuring is often not received well by investors and analysts.

Essential Points

• A reverse stock split merges existing shares into a smaller number of proportionally more valuable shares.
• A stock split has no direct effect on a company’s value, only the number of shares and price per share. However, investors will often interpret such a move as meaning a company is struggling.
• A company’s board of directors may choose to perform a stock split in order to avoid being delisted from stock exchanges with a minimum share price, to reduce the number of shareholders, or to counter declining stock values.

Reverse Stock Splits Explained

A reverse stock split occurs when the board of directors of a company chooses to reduce the company’s number of stock shares with a smaller number of more valuable shares.

This works in the reverse of a regular forward stock split which divides each current share of stock into multiple stocks of proportionally less value.

In a reverse stock split, multiple shares of stock are merged to leave investors with fewer shares of proportionally more valuable stock shares.

As a result, the market value of the company and the value of an investor’s holdings are left unchanged, but the price per share is proportionally increased.

Calculating the effect of a reverse split is relatively simple.

The number of shares is divided by the split ratio, such as 1 for 20 or 1 for 100, and the price of shares before the split is multiplied by the same amount.

For example, consider an investor that holds 10,000 shares of stock in a company with a share price of $10.

If the company declares a 1-for-20 reverse split, these 10,000 shares will be divided by 20, leaving 500 shares each priced at 20 times their pre-split value.

This means that each share of stock will be priced at $200 following the reverse split, though the total value of the investor’s holding will remain unchanged.

This proportionate change in value is because the company made no actual change in value through performing a reverse stock split.

As a result, the reverse split will not directly impact the company’s overall value and, thus, market capitalization in any way.

The factor the company’s board of directors chooses for the reverse split will instead become the multiple by which the share price will be adjusted when the split is performed.

In cases where an investor holds fewer shares than the split ratio, they would generally simply receive a cash payout instead of receiving fractional shares.

For example, if a company performed a 1-for-50 reverse split, then shareholders with fewer than 50 shares would receive a cash payment in lieu of shares.

This can reduce the number of a company’s shareholders, and in some cases, this may be the intent of a reverse stock split.

Advantages & Disadvantages of a Reverse Stock Split

Advantages of a Reverse Stock Split

There are several advantages to a reverse stock split which may lead a company’s leadership to choose to announce such a move.

These include:

• Preventing Delisting by Major Stock Exchanges: Many stock exchanges have a minimum price per share requirement for listing. If a company’s stock falls below this level for a significant period of time, the exchange may delist the company. This can have a major effect on a company’s ability to raise capital, relegating it to a penny stock that will be difficult to buy and sell. If a company’s share price is nearing this level, a reverse stock split can help it to avert delisting by raising per share prices.
• Attract Major Investors: Many institutional investors and mutual funds maintain policies requiring a minimum share price in order to take a position in a company. Simply retaining a high enough share price to qualify for listing may not mean that a company’s stock price is high enough to qualify for purchase by these investors. Remaining above this threshold may make a significant difference to a company’s ability to attract large investors.
• Reduce the Number of Shareholders: In many jurisdictions, the number of shareholders a company has will play a role in determining the regulations to which it will be subject. If a company keeps below a certain number of shareholders, it may retain a preferred regulatory status.
• Increase Spin-off Pricing: For companies planning to spin off a new company, often stock prices for the new company will be heavily influenced by the existing stock prices of the parent company. By performing a reverse split, the parent company can gain far higher share prices, potentially allowing it to gain far higher prices for the spin-off.

Disadvantages of a Reverse Stock Split

A reverse stock split also has several disadvantages, which a company must take into consideration before taking such a step.

These include:

• Negative Reception by Market Participants: In most cases, a reverse stock split is not interpreted positively by current and potential investors. Generally, this is taken as an indication that a company’s stock prices have fallen to a low level, and the company is attempting to artificially bolster its value without making any meaningful changes to its activities.
• Reduced Liquidity: By reducing the number of shares on the open market, a company may lose a degree of liquidity.

Reverse Stock Split Example

As an example of a stock split, consider the XYZ Corporation, which has one million outstanding shares of stock trading on the market for $10 per share.

The company’s share price has been declining for a significant period of time, and management wants to artificially raise prices to remain relevant.

As a result, the company’s management decides to perform a reverse split with a 1 to 20 split ratio.

This means that every twenty shares will be merged into a single share with a proportionally higher share price.

Once the reverse stock split is complete, XYZ Corporation will be left with only 50,000 outstanding shares, each with a price of $200 ($10 * 20).

Recent Real Market Example of a Reverse Stock Split

A recent example of a reverse stock split occurred in 2021 with the General Electric stock split.

The company had been suffering from poor performance for several years and sold multiple of its most recognizable segments.

With declining share prices and reduced scope of business General Electric chose to perform a reverse split.

On July 30, 2021, the company announced that the GE shareholders had approved a 1-for-8 reverse stock split.

The GE reverse stock split authorized a share reduction and par value reduction and was adjusted on August 2, 2021.

The split took every eight shares of outstanding and treasury common stock shares and replaced them with one share of proportionally adjusted common stock.

This reduced the number of outstanding shares of GE common stock from roughly 8.8 billion to 1.1 billion shares.

For shareholders that held less than eight shares of stock, the GR reverse split did not provide fractional shares.

Instead, these shareholders that would receive a fractional share as a result of the GE reverse split received a cash payment in lieu of fractional shares.

Though the move raised the per-share price of GE’s common stock, and investors saw a proportional raise for the reduced number of shares in their portfolios, investors did not interpret the move well.

Over the following year, GE’s market cap dropped by 40%.

Why Would a Company Reverse Split?

A company will most often choose to undergo a reverse split when share prices fall so low that it would put the company at risk of becoming delisted from major stock exchanges.

This may result from poor management, changes in market behavior, or in some cases, it may be performed by smaller companies that rely on performing research and development rather than marketing and selling products or services.

Becoming delisted can have devastating results for a company’s liquidity, and a company may choose to accept the negative stigma that accompanies a reverse split in order to remain listed.

Other reasons to perform a reverse split include bolstering share prices in order to attract major investors that require a high minimum share price as well as to reduce a company’s number of shareholders for regulatory reasons

Final Thoughts

By performing a reverse stock split, a company reduces the number of shares that each investor owns but proportionally increases the value per share.

This means that it has no direct effect on the company’s market cap.

This tactic is often used by companies facing declining share prices to avoid the risk of delisting.

As a result, reverse stock splits are often viewed in a negative light.

FAQs

Do you lose stock in a reverse split?

Investors will not directly lose any money as a result of a reverse split.

However, they will see a lower number of shares in their portfolio after the split is completed.

This is because a reverse split essentially consolidates shares into a smaller number of shares that retain the same value.

This means that if you owned 100 shares of a stock trading at $1 per share and the company announces a 1-for-10 reverse stock split.

Then after the split, you will own ten shares of stock at $10 per share.

The broker will handle the entire process, it will not have any tax effect, and you won’t need to do a thing.

Is a reverse split good or bad?

Generally, reverse splits are seen by investors and analysts as a poor indicator of a company’s performance.

Often this is a signal that a company’s share prices have fallen, and the company may be facing the risk of being delisted.

Because a reverse split does not make any material changes to either a company’s operations, marketing, or product offerings, it will not serve to improve the company’s performance, only its stock price.

Due to the negative perceptions associated with a reverse split and the lack of any material change, a company’s stock prices may continue to fall.