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by Jonathan AnthonyNavigating Reverse Stock Splits: Understanding When, Why, and How They Impact Your Investments
A reverse stock split merges shares to increase stock prices.
Low stock prices are a problem for both investors and companies. All kinds of challenges can arise when the share prices get too low.
To mitigate these challenges, companies might choose to merge shares as a way to boost share prices. This is called a reverse stock split.
While an individual investor cannot do anything about it, understanding what it means and why the reverse stock split occurs can help you be a more savvy investor.
In this blog post, we’ll explain the details of reverse stock splits and how this action can affect your portfolio.
Reverse Stock Splits Explained
Let’s look at a normal stock split first. In this case, a high share price might be turning away new investors.
To reduce the price and increase the number of shares available, a company can divide each existing share into multiple new shares with a proportional price.
For example, company XYZ has a million shares worth $100 each, and they decide to do a 2-for-1 stock split. Now, they have two million shares worth $50 each.
If you were an investor in the company, you now have double the shares, but they maintain the same total value.
A reverse stock split is the same process in reverse. Rather than splitting stock, the company merges existing stock to reduce the overall number of shares and increase the stock price.
This process is also called a share rollback, a stock consolidation, or a stock merge.
For example, company ABC has ten million shares worth $1 each and decides to do a 1-for-10 reverse stock split.
Now, they have one million shares worth $10 each. Again, the overall value didn’t change, just the number and price of the individual shares.
Reasons for Reverse Stock Splits
Companies usually implement a reverse stock split because the share price has fallen too low, and they don’t have a good way to increase it in the short term. Here are some specific reasons why a company might take this action:
Stock Exchange Listing Compliance
Stock exchanges usually have minimum price requirements for listed companies. A reverse stock split can help a company meet these requirements by boosting share prices.
If a stock is faced with delisting or reverse split, they will choose the latter as it’s better to survive than to disappear into oblivion.
Institutional Investor Requirements
Mutual funds and other institutional investors also have minimum share price requirements for portfolio inclusion. A company might implement a reverse stock split to boost prices to meet these requirements.
Improved Stock Perception
Generally, higher stock prices are more attractive to investors. If the company wants to increase investor attention, increased share prices can make the stock more appealing.
Reduced Volatility
Low-priced stocks tend to have higher price volatility. Increasing the stock price through a reverse stock split can help minimize price fluctuations and add stability to the price curve.
Corporate Restructuring
If a company is restructuring and/or rebranding, they might take it as an opportunity to implement a reverse stock split to boost prices while changing their name, changing their ticker symbol, and creating a new image.
Reduced Shareholders
If a company wants to reduce the number of shareholders, a reverse stock split can have this effect. For example, in a 1-for-100 reverse split, anyone holding less than 100 shares will receive a cash payout rather than fractional shares.
Problems With Reverse Stock Splits
Negative Perception
The biggest problem with a reverse stock split is that it’s usually perceived as a desperate move by a failing company, which can turn away potential investors, further exacerbating the problem.
No company would do a reverse stock split unless they were otherwise out of options.
Short-term Price Drop
With negative perception, the reverse split will usually cause an actual drop in price distinct from the price adjustment caused by the share merger. The company hopes this will be a temporary market reaction.
Reduced Liquidity
As fewer shares are now available, it can be more difficult for investors to buy and sell shares.
Signs on Pending Reverse Stock Splits
Falling Share Price
This might be the most obvious sign of an impending reverse split.
Share price requirements for exchanges or institutions are publicly available, so you’ll know if that threshold is about to be breached and that the company might need to make a tough decision.
Announcements and Rumors
Companies might announce reverse stock splits ahead of time, or you might see rumors that hint drastic changes might be imminent.
This is where it’s important to always pay close attention to news about the stocks you own. Any info can become part of an overall analysis of what might happen next.
Financial Difficulties
Don’t just look at the stock info; keep an eye on the fundamentals as well. If a company is struggling financially, a stock price drop is usually around the corner.
This is especially important if the stock price is already dangerously low.
Shareholder Approval
Most of the time, companies can enact a reverse stock split with a board decision only. However, sometimes companies require shareholder approval before a stock merger.
How Reverse Stock Splits Impact Your Investments
Generally, reverse stock splits are something you don’t have control over. The only thing you can do is get out of a stock before a reverse split, avoid buying stocks that were recently reverse split, or buckle up and stay for the long run.
Here are a few ways a reverse stock split can impact your portfolio:
Reduced Shares
The first impact you’ll notice is the most obvious, as you’ll have fewer shares of the stock than you had before, though (ideally) the overall value of your investment remains the same. Unless…
Price Drop
As reverse stock splits are viewed as a sign of weakness, investors will often sell shares, causing a (hopefully) temporary drop in price. If the company is otherwise a strong buy, the price should recover.
This also creates a buying opportunity if you are otherwise interested in the stock.
Tax Implications
Even though the value of your investment remained constant, there still might be tax implications. These effects will be highly individual, so be sure to consult a tax pro to know exactly how your situation might be affected.
Psychological Effects
While hard to measure, knowing a stock you’ve invested in has implemented a reverse split can be disheartening as this might be a sign you’ve invested in a failing company.
Reduced Volatility
As the individual share price is now higher, a reverse split stock will have a less volatile price than before the split, which might be a benefit depending on your own tolerance for risk.
Reduced Liquidity
If a stock in your portfolio is reverse split, you will have more of your funds tied up in a single share, which means your investments are now less liquid.
If it is a 10-for-1 reverse split, this might be irrelevant. But if it’s a 100-for-1 split, the impact could be more significant.
Conclusion
We hope you have a better understanding of reverse stock splits and what to expect if a stock you own undergoes this process.
While generally perceived as a sign of desperation from a company fighting for survival, it might not have much impact if you’re in it for the long haul.
The key is to understand what’s going on and not panic. Making an emotional investing decision is almost always the wrong move.
If your portfolio is properly diversified, no single stock should have that much impact. Stick with sound long-term investing principles so that reverse stock splits will only be a minor event in your overall investing journey.
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