While a stock split can often be associated with a company looking to grow, a reverse stock split can sometimes signal that a company is in distress
If you are lucky enough to have invested in Apple (NASDAQ: AAPL) when it IPO’d in 1980 at $22 per share, then you will likely know exactly what a stock split is. You are probably currently snorting in derision at this lowly writer’s explanation from your gold-plated mansion as a result of the riches gained from such a keen investment.
Simply put, a stock split is when a company increases its number of outstanding shares and commensurately decreases those shares’ value. So if you had 10 shares in ACME worth $20 a pop, after a 2 for 1 stock split, you would own 20 shares in ACME worth $10 a pop
Apple’s stock has split four times since its IPO: This means that a $22 share in Apple bought in 1980 would have turned into 56 shares today, which would bring in roughly $15,500, as of April 1, 2020.
So that’s a stock split, but have you ever heard of a reverse stock split?
What does reverse stock split mean?
As you may have guessed, a reverse stock split is the opposite of a good ol’ fashioned stock split. Simply put, it is a corporate action that consolidates the number of existing shares of stock into fewer, proportionally more valuable, shares.
A company reduces the number of outstanding shares it has made available to the public, and can be also referred to as a ‘stock merge’, ‘stock rollback’, or ‘stock consolidation’.
It works like this:
- Say a company has 100 million outstanding shares (stock currently held by all its shareholders) valued at $1,000 per share.
- The company’s board decides to go for a 1-for-5 reverse stock split, merging 5 shares into 1.
- The company now has 20 million outstanding shares valued at $5,000 each.
Why would a company perform a reverse stock split?
Generally, a reverse stock split is the result of a company not performing well. It’s rare in business, but with the COVID-19 pandemic wreaking havoc on Wall Street, it may become more common. Following the dot-com bubble, there were more than 700 reverse stock splits in 2001 alone. Here are some potential reasons to do so:
The company’s stock is in freefall and the company does not wish to be delisted from an exchange. To be listed on one of the major indices — Nasdaq (NASDAQ: NDAQ), Dow Jones Industrial Average (NYSEARCA: DIA), and S&P 500 (NYSEARCA: VOO) — a stock has to be worth a certain amount. For example, a share must cost more than $4 to be listed on the NYSE. Should a stock fall below $1 it could be delisted, so the company will perform a reverse stock split in a bid to increase the single share price of its stock. Amidst this downturn there are some stocks such as NIO (NYSE: NIO), Nautilus (NYSE: NLS), or even GoPro (NASDAQ: GPRO) which are flirting with such lows.
A reverse stock split could also be used to improve a company’s image to investors. Single-digit stocks are not exactly enticing and pose a riskier investment than something that is worth more. Not the most solid investment thesis, but someone who does not know much about investing is likely to go for Beyond Meat’s (NASDAQ: BYND) $25 per share price when it IPOed, than the much more established Ford Motors (NYSE: F), which has hovered below $10 for some time now. A higher stock price draws more attention from analysts and could be a source of marketing for a struggling company.
The effects of a reverse stock split
The reverse stock split has no effect on a company’s value, simply increasing the individual share price, and investors still hold the same value in the company. However, it should be a red flag for investors.
Think of it as a hail mary throw from a company’s board; a desperate bid to raise the share price and get investor sentiment back on board. Sometimes it works, sometimes it doesn’t. In 2002, AT&T (NYSE: T) performed a 1-for-5 reverse stock split as it believed its planned Comcast (NYSE: CMSCA) merger at the time would send stock plummeting. The merger didn’t take place, and AT&T stock remains a volatile stock over the past decade.
In general though, the companies performing stock consolidations are underperforming, non-profitable, and small-cap.
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