Introduction

If you own shares in a publicly-traded company that has just announced a reverse stock split, you might be wondering what the heck is a reverse stock split and how will it affect my investment?

If this sounds like a situation you currently find yourself in, then this article will provide you with all of the details that you need to know about how does this works!

What is a Reverse Stock Split?

A reverse stock split is a process by which a company reduces the numbers of its shares that are publicly traded.

The company will reduce the number of outstanding shares in proportion to the ratio of the reverse split agreed upon by the Company’s board of directors meaning that the amount of new shares you will receive is in direct proportion to how many shares you owned before.

Each shareholder will still own the same percentage of the outstanding shares prior to and after the reverse stock split, however, the number of shares that they hold will be reduced by the ratio of the reverse split.

The Mechanics of a Reverse Stock Split

Once a reverse stock split is approved by the Company’s board of directors, this planned corporate action is then announced to the public via a press release.

This release will often detail the split ratio, as well as the date when the consolidation will go into effect and how fractional shares will be handled.

Here is an example of a recent reverse stock split announcement from GROUPON (Ticker: GRPN) : GROUPON

In this example, Groupon announced a 1-for-20 reverse stock split which will go into effect on June 11, 2020.

This means that for every 20 shares an investor owns prior to the reverse stock split,  they will receive 1 share post-split.

So if you owned 1000 shares of Groupon prior to the reverse split, you will own 50 shares post-split ( 1000 shares divided by 20).

What about share prices?

When a company performs a reverse stock split, the share prices will generally increase by a multiple of the split ratio. Example of Groupon

Using the Groupon example again, the closing price on June 10th, 2020 was $1.39, which means that an investor with 1000 shares would have an investment valued at $1,390.

After the reverse stock split occurs, the investor will now hold 50 shares at the new price of $27.80 ( $1.39 x 20) making the value of the investment the same at $1,390.00

Something important to note is that the company’s total market cap remains the same before and after the reverse split – nothing about the company has changed other than the number of shares available and the share price!

Why Would A Company Perform a Reverse Stock Split?

At this point, you might be wondering why a company would perform a reverse stock split if nothing really changes other than the number of outstanding shares available – and that’s a very valid question!

To understand the rationale behind reverse stock splits it is important to understand exchange listing requirements!

In order for a company to be listed on a major stock exchange, such as the NYSE or NASDAQ, it must meet several minimum financial and non-financial requirements.

 

These vary between exchanges, however, the most common include:

  • Minimum number of shareholders who own more than 100 shares of stock
  • Total number of publicly traded shares
  • Minimum stock price *

The minimum stock price requirement is the big one here because a company can be delisted from the exchange if its stock price falls below a certain threshold for a number of consecutive days.

To avoid being delisted from the exchange for failing to meet the minimum stock price requirements, companies will often perform a reverse stock split to boost its stock price!
Another reason why a company might consider a reverse stock split is to boost the company’s image, basically a PR stunt!

Institutional investors and analysts tend to stay away from lower-priced stocks, especially those under the $5 range, so by performing a reverse split and increasing the share price, these companies can attract more attention and potentially bring in more investors.

 

Are Reverse Stock Splits Good or Bad for Shareholders?

Reverse stock splits are generally considered to be very negative signs for a company, however, there are some situations where they could be considered positive!

More often than not, when a company announces a reverse stock split, the share prices have fallen so low that they are at risk of being delisted from an exchange.

If this is the case and a company announces a reverse stock split but then continues on with business as usual, then investors will view this as nothing more than a distraction during times of corporate uncertainty which would be negative for shareholders.

If a company that has seen its shares beaten down, announces a reverse stock split accompanied by sweeping changes in leadership, management, or strategy, then this would be viewed a bit more positively by investors.

The only time when a reverse stock split would be good for shareholders is in the case where a company is trying to get listed onto a major stock exchange from the pink sheets market – in this scenario, the transition from OTC to a major stock exchange would likely attract more interest from investors!

 

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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.