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 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 five times since its IPO: This means that a $22 share in Apple bought in 1980 would have turned into 224 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, Dow Jones Industrial Average, and S&P 500 — 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, Nautilus, or even GoPro 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 $25 per share price when it IPOed, than the much more established Ford Motors, 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 performed a 1-for-5 reverse stock split as it believed its planned Comcast 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.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.