Reverse Stock Split Meaning Example How It Works

Reverse Stock Split Meaning

Say a company has undertaken a reverse stock split in the ratio of 1:2. Consequently, every two of its shares will become 1, doubling the price of each share. It is a kind of stock restructuring that does not affect the market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more of the stock.

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Key Takeaways

A reverse stock split is a corporate stock restructuring strategy where they combine the shares, which raises the price of each share.Say a company is consolidating its shares in the ratio of 1:2. Consequently, every two of its shares will become 1, doubling the price of each share.It doesn’t impact the company’s market capitalization or corporate valuation.Companies adopt this strategy to aviod getting delisted from the stock exchange (NYSE or NASDAQ) on non-adherence to the minimum $1 stock price criteria.The consent of shareholders is essential for reverse splitting.

How Does a Reverse Stock Split Work?

Often, shares that are trading at such a high price witness a split to form new ones known as stock splitting. The primary reason for splitting a share into new ones is to lower its cost. It enhances its affordability to potential investors.

On the other hand, companies use reverse stock split to inflate the per-share value when their stock price is constantly falling. In a 1-for-4 split, a shareholder of four shares will end up with one share.

The price of one share will be the sum of all the four shares, enhancing the per-share value. The market capitalization value remains the same as there are no new additions, only a restructuringRestructuringRestructuring is defined as actions an organization takes when facing difficulties due to wrong management decisions or changes in demographic conditions. Therefore, tries to align its business with the current profitable trend by a) restructuring its finances by debt issuance/closures, issuance of new equities, selling assets, or b) organizational restructuring, which includes shifting locations, layoffs, etc.read more. Let us understand the concept better with a recent example.

For instance, the United States Oil Fund (USO), with its shares trading at around $2 in 2020, went through a reverse stock split to raise the per-share price to $18. USO reduced its 1.5 billion outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company’s shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner’s equity in the liability side of the company’s balance sheet.read more to 185 million. If its share price had fallen below $1, it could have been delisted from the stock exchangeStock ExchangeStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ.read more.Companies need to maintain their position on the top exchanges like NASDAQ and NYSE. These stock exchanges have specific criteria that the companies need to fulfill for getting stocks listed. One such condition is not to have a share value lower than $1 for 30 days or more.The share price could fall due to the underperformance of a company that is reporting constant losses. Increased debts, scams, or recession could also severely affect a firm’s profits and stock price. USO had reported unrealized losses of $726 million in March 2020. If in this period, their stock price had fallen below $1, they could have been delisted from the relevant stock exchange.Apart from delisting, other reasons behind consolidating the shares include increasing liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, controlling volatility, and serving the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more better.

Reverse Stock Split Examples

The below-mentioned reverse stock split examples outline how it works using calculations to help you understand its meaning better.

Example with calculations

ABC Limited is trading on the stock exchange, with each share costing $2. There are 2400000 outstanding shares. Thus, the market capitalization of the company is $4800000. Therefore, the company wants to attract high net worth investors and as such it goes for a reverse split of 1 for 30 shares.

Therefore,

Reverse stock split ratio or RSP is 1:30; original share price or OP is $2; Original Number of Shares or OS is 2400000.New price per-share or NP = OP X The number of shares consolidated = 2 X 30 = $60New number of shares or NS = OS ÷ RSP = 2400000 × (1 ÷ 30) = 80000 sharesMarket capitalization before the split = NP × NS = 60 × 2400000 = $4800000Market capitalization after the split = 60 × 80000 = $4800000

What happens to the shares held by the investor after the split?

The investor who holds 3000 shares worth $6000, i.e., $2/share, before the reverse split, now owns 100 shares of $60 each, still totalling $6000 in worth. Many reverse stock split calculators help investors compute their investment value after the consolidation.

Examples from history

The financial history is rich with examples that also throw some ideas on whether a reverse stock split is good or bad. Other than USO, some other companies to have opted for this split are Citibank, Royal Bank of Scotland (RBS) or NatWest, Xerox Corporations, AIG, Tyco, Titanium Metals, etc. For example, LM Funding America, Inc. went ahead with a 1 for 5 consolidation recently to stay on the NASDAQ by maintaining the share price above $1.

Is Reverse Stock Split Good or Bad?

While investors lose some shares, they still retain the same value. However, the circumstance under which a company has opted for a reverse split gives weight to investors’ fears. Many experts have observed that a financially troubled company usually opts for a share consolidation to boost its stock price artificially. Such shareholders will inevitably fear losing their savings to further falls if they don’t disinvest.

Although, some companies have risen from the brink of underperformance. In 2011, Citigroup opted for a 1 for 10 split, raising its share price to $40 each after trading at $4.5 for a while. It was a move to control volatility and reinstate its quarterly dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more. Today Citi’s stock price is beyond $70, with it reporting $7.94 billion in profit, triple from 2020.

Similarly, NatWest had undergone a 1 for 10 split in 2012 amidst government bailouts after being painfully struck with the financial crisis. Like Citi, the bank worked on its profits. In 2019, it had reported 4.2 billion pre-tax profits. However, many companies haven’t been able to bounce back even after the split, such as AIG and Tyco.

Besides losing your shares, such splits create problems like odd lotsOdd LotsAn odd lot refers to a stock order involving the sale or purchase of fewer than 100 shares, such as 19. For ease of exchange, stock exchanges trade stocks in a standardized unit such as 100 or 1000 shares. However, many small investors cannot afford to invest in a huge portion, leading them to spend on an odd lot of expensive stocks.read more and fractional shares. Many investors and stock exchanges do not prefer odd lots, while fractional sharesFractional SharesFractional share refers to just a part of equity stock which doesn’t amount to a single stock unit. Such shares are acquired after stock splits, merger or acquisition, dividend reinvestments, capital gains and dollar-cost averaging. The shareholders cannot sell these stocks in the open market.read more affect voting rights. As such, many experts suggest keeping a close watch on the company’s performance after the split.

If a distressed firm brings itself up from the downfall and its profits improve, the split might not be so bad. Also, sometimes, the consolidation happens with the intent to serve the shareholders better. If these parameters are missing and the share price continues to fall, it might be a sign of worry. Being observant of the post-split activities can help investors from future losses by timely disinvesting.

Reverse Stock Split Advantages

Apart from delisting, the following are advantages of the reverse split.Match Stock Price of Competitors: If the competitor company’s share value is relatively high, it will appear more attractive. The split will help the company secure an equivalent share price to stay in investors’ good books.

Seek Attention from Big Investors: Many high-net-worth institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more, mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more and pension funds let go of certain stocks due to their low share price. The split prevents this.

Other advantages – It helps stocks become more liquid and less volatile. Besides, bear investors take falling and low stock prices as a downtrend sign which furthers affect the price.