What is a Reverse Stock Split? Pros, Cons & How to Profit.
A reverse stock split is when a company reduces the total number of outstanding shares. For example, if a company has one million outstanding shares and declares a 1-for-2 reverse stock split, the company will have 500,000 outstanding shares after the split. In other words, each shareholder will own two shares for every one share they owned before the split.
What is a reverse stock split?
The purpose of a reverse stock split is to increase the per-share price so that the company can be traded on a major exchange. For example, the minimum price per share to be traded on the Nasdaq is $1. To meet this listing requirement, a company whose stock is trading below $1 can do a reverse stock split to increase the per-share price.
While most people think of stock splits as something that only happens when a company’s share price gets too high, there are a few different reasons why a company might opt to do a reverse stock split.
In this blog post, we’ll take a comprehensive look at reverse stock splits: what they are, how they work, and why companies might choose to do them.
Why do companies do reverse stock splits?
The reasons companies do reverse stock splits are to boost share price and investor confidence and to improve liquidity while lowering transaction costs.
5 reasons companies do reverse stock splits:
- The most common reason is to increase the per-share price so the company can list on a major exchange.
- To boost investor confidence: If a company’s stock price has fallen significantly, doing a reverse stock split can make the stock look more attractive to investors and give them confidence in its future prospects.
- Another common reason for doing a reverse stock split is to increase liquidity; because investor demand tends to be higher for stocks with higher prices, companies will sometimes do reverse splits to increase trading activity and generate interest in their stock.
- To make it easier to buy and sell shares: When the per-share price is too low, it can be difficult for brokers to execute trades without incurring significant losses. By doing a reverse stock split, brokers can buy and sell shares more easily without taking on as much risk.
- To save on transaction costs: When a company has millions of outstanding shares, it can incur significant costs every time it buys or sells shares of its stock. A reverse stock split decreases the number of shares, which reduces transaction costs.
How do reverse stock splits work?
A reverse stock split is when a company reduces the number of shares outstanding while proportionately increasing the share price. For example, if a company does a 1-for-2 reverse stock split, each shareholder would end up with half as many shares as they owned before, but the price of each share would double.
Example: What happens in a reverse stock split?
A reverse stock split is when a company decreases the number of shares outstanding while increasing the price per share. Let’s use an example to illustrate how this works in practice. Imagine ABC Corp has 1 million shares outstanding, and each trades for $10 per share. After doing a 1-for-2 reverse stock split, ABC Corp would have 500,000 shares outstanding, and each would trade for $20.
So even though shareholders would own half as many shares as they did before the split, the cost basis of their investment would remain unchanged because the total value of their holdings (i.e., the number of shares times the price per share) would stay the same: 1 million shares x $10 per share = 500,000 shares x $20 per share.
Are reverse stock splits a defense against short sellers?
No, reverse stock splits do not negatively affect short sellers. A common myth is that reverse stock splits can also be used as a defensive measure against short sellers; if short sellers believe that a company’s share price is going to fall sharply, they may initiate large short positions in anticipation of this drop. If enough short sellers pile into a position, it can actually drive the price down even further (a phenomenon known as “short selling pressure”).
To combat this pressure and prevent their share price from falling too low, companies will sometimes do reverse splits, making it more expensive for short sellers to maintain their positions.
Do short sellers benefit from reverse stock splits?
Yes, short sellers can benefit from reverse stock splits. A 2021 study by Ryan Voges at Utah State University reveals that stock prices get additional downside price pressure 20 days after a reverse stock split because even more short sellers are attracted to the company. In short, after a reverse stock split, “stocks experience negative cumulative abnormal returns.”
How to profit from a reverse stock split
A 2018 study by Kim, Klein & Rosenfeld suggests that short sellers can profit from a reverse stock split because company share prices decline abnormally in the 3 years after the split is enacted.
Are reverse stock splits good?
Whether or not a reverse stock split is good for a company depends on a variety of factors. First, it’s important to note that while reverse stock splits can be seen as a sign of desperation by investors, they can also be viewed as a positive move by companies that are looking to improve their appearance or increase liquidity.
Additionally, it’s worth noting that reverse stock splits usually don’t have a long-term impact on the share price; while the stock may jump initially after the split is announced, it usually drops back down to its previous level once the initial excitement dies down.
Problems with reverse stock splits
Although there are some benefits to doing reverse splits, there are also some drawbacks that investors should be aware of before buying stocks that have undergone this type of corporate action.
- The share price increase is only temporary: The biggest benefit of a reverse stock split is that it increases the per-share price in the short term. However, this benefit is only temporary because earnings and cash flow don’t change due to the split. As such, the share price will eventually revert to where it was before the split once investors realize that the fundamental underlying business hasn’t changed.
- It can be viewed as a sign of desperation: Because reverse splits are often done by companies whose share prices have fallen precipitously, doing one can be viewed as a sign of desperation by investors. This negative perception can further pressure the share price lower after the announcement of the split.
Reverse stock splits summary
Companies undertake reverse stock splits for various reasons ranging from trying to meet listing requirements on major exchanges to reducing transaction costs incurred from buying and selling shares of their stock.
However, investors should be aware of some disadvantages associated with this type of corporate action before buying stocks that have undergone reverse splits, including the fact that any increase in per-share prices will only be temporary and that reverse splits can sometimes be viewed as a sign of desperation by investors which could pressure the share price lower after the announcement of the split.
In this article, we’ve looked in-depth at reverse stock splits: what they are, how they work, and why companies might choose them. We hope you found this informative!
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