What Is a Reverse Stock Split?
Businesses can reduce the number of outstanding shares in the market by implementing a reverse stock split. The stock price of the company rises as existing shares are combined into fewer, proportionally more valuable shares.
How a Reverse Stock Split Works
A company cancels its present outstanding stock during a reverse stock split and issues new shares to its shareholders in proportion to the number of shares they had before the reverse split.
In a one-for-ten (1:10) reverse split, for instance, stockholders get one share of the new company's stock for every ten they already owned. In other words, following the reverse stock split, a shareholder who originally owned 1,000 shares would ultimately own 100 shares.
The overall market capitalization of the firm remains intact after a reverse stock split is implemented, meaning that it has no inherent impact on the company's value. Although the corporation has fewer outstanding shares, the reverse stock split directly improves the share price.
Additionally unchanged is the investor's holdings' total share value. A one-for-10 reverse stock split would result in an owner holding 100 shares worth $10 each instead of 1,000 shares worth $1 each. Therefore, the investor's shares would still be worth $1,000 as a whole.
Future profits for businesses that distribute cash dividends would simply be adjusted to reflect the new, lower number of shares outstanding. For example, if a business previously distributed a dividend of $1 per share and undergoes a 1:5 reverse split, the dividend would increase to $5 per share or five times the previous payout. Keep in mind that the total amount of dividend payments ought to stay the same.
Reasons for a Reverse Stock Split
Avoiding being delisted from an exchange: Stocks that are subject to minimum share price regulations run the danger of being delisted from stock exchanges if their price falls below $1. A large exchange listing is necessary to draw equity investors, and in some situations, increasing share values through reverse stock splits is the only way to avoid removal.
Improve the company's reputation if the stock price has fallen markedly: Particularly if the price is close to $1 or the stock is seen as a penny stock by investors, a stock that is trading in the single digits is probably seen as a dangerous investment.
Criticism of a Reverse Stock Split
There are drawbacks to reverse stock splits. Companies seeking to artificially increase their share price in this way frequently run the danger of losing the favor of investors.
Reverse stock splits may be viewed negatively. As previously said, if a company's share price has dropped so low that it faces delisting, it is more probable that it will execute a reverse stock split. Investors may therefore think the company is in trouble and consider the reverse split to be nothing more than an accounting trick.
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