What is the Meaning of Reverse Stock Split? Why Do Companies Do Reverse Stock Splits?

Reverse Stock Split: An Overview

Stock splits are usually linked with good news since they commonly occur after a stock has done well and result in an increased number of shares owned by each owner. However, those splits, officially known as forward stock splits, are just one type. A business may also carry out a reverse stock split, which operates in the exact opposite manner. Reverse stock splits, in contrast, to forward splits, reduce the number of shares investors own, and they frequently happen when a stock has lost a significant proportion of its value.

Let us dive into the fundamentals and implications of a reverse stock split with all that one need to know about the concept. 

What is the Meaning of Reverse Stock Split?

When a company's board of directors agrees to replace a particular number of outstanding shares with a lower number, it is known as a reverse stock split. Similar to conventional stock splits, reverse stock splits operate in the reverse direction. In a reverse split, investors are given many shares in exchange for fewer shares. Since the new share price is proportionately greater, the company's overall market value remains the same. Usually, it is based on a fixed ratio. For instance, a reverse stock split of 2:1 would result in the distribution of 1 share for every 2 shares already held by an investor.

Although the number of shares outstanding declines as a result of a reverse stock split, the stock price is modified to reflect this change while the market capitalization of the firm stays constant. In other words, a reverse stock split has no impact on shareholder value. Reverse stock splits are frequently used by businesses in order to increase the per-share price; the resulting ratios can be as low as 1-for-2 and as high as 1-for-100. Although reverse stock splits are frequently the consequence of a company's shares losing a significant amount of value, they have no influence on a company's capitalization.

Criticism of a Reverse Stock Split

• A reverse stock split is terrible because it can be a sign of trouble for a company. If a company is struggling financially and decides to do a reverse stock split, this could be an attempt to hide financial problems.
• A reverse stock split is sometimes done to hide financial problems. If the share prices of your favorite companies drop substantially over time and you want to repurchase them at their previous high price, you may need more money than you have on hand—and what better way to raise capital than by conducting a reverse stock split?
• Reverse stock splits can signal issues with how the company is being run or managed. In some cases, this could indicate fraud or other illegal activity on the part of management or board members; if that's happening at your favorite companies (or those that you might invest in), then these shares might not be worth buying anymore!

Should I sell my stock before a reverse stock split?

Selling before a reverse stock split is a good idea, but selling after the reverse stock split is not.

Since you can sell before and after a reverse stock split, selling during one is optional. The main advantage of selling before the reverse stock split is that you don't have to wait around for it to happen. However, if you want to make more money by holding onto your shares until they've risen in value again (after they've been divided), you may want to sell after the reverse stock split instead.

Is a reverse stock split good?

Reverse splits are neutral. Technically, it permits a business to issue additional stock. Reverse splits increase the number of outstanding shares, which may dilute the stock price. Market capitalization is affected, not assets or profits (and, therefore, capitalization ratio).

Reverse stock splits may be helpful or harmful for investors, depending on the circumstances and what happens afterward. Suppose your firm has continuously increased sales and suddenly announces plans for another round of funding via new share issuing. This might imply something terrible about their prospects, but you shouldn't liquidate all your shares because "something horrible must be occurring!"

Is a reverse stock split excellent or bad?

If you're thinking about investing in a company that has done a reverse split, here are some things to consider:

Understanding how a reverse stock split is likely to affect the price of your investment because, while it may seem like splitting stocks would be suitable for investors, it can adversely affect their value. A reverse stock split typically reduces share prices by dividing them into higher numbers of shares. The amount of money each investor receives from owning 1/100th of 1% less of the total number of outstanding shares will fluctuate based on market conditions when they purchase their stocks.

Example of a Reverse Split

Let us take an example to understand how a stock split functions and what is its impact on an investor’s holdings. Suresh, a novice investor, presently owns 150 shares of the XYZ Company for a price of ₹100, representing a ₹15,000 investment. XYZ Company declares a 50:1 reverse stock split and has 100,000 shares outstanding. Shares have been changed from 50 shares per shareholder to 1 share. The change in the structure of shares outstanding, there is a direct effect on Suresh's stake in the Company, in the following context:

First, the market value of XYZ Company is ₹1,00,00,000 with 100,000 shares outstanding and a share price of ₹100 each. Second, a  50:1 reverse split also results in a post-split share count of 200 (100,000 / 50 = 2000).  Third, we are aware that a reverse stock split has no impact on market capitalization. Therefore, the 2000 shares that are now in circulation must be added for a market value of ₹1,00,00,000. As a result, the value of each share has increased to ₹5,000 (₹1,00,00,000 / 2000 outstanding shares). The XYZ Company has 2000 shares, thus Suresh now owns 3 shares in the company. Suresh's stake in XYZ Company remains the same at ₹15,000.

General Electric's 2021 reverse stock split: interesting as they have given a real-life example for better clarity

An example: 2021 GE reverse split.

General Electric (GE) divided its shares 2-for-1 in October 2018, so you'll get two new shares for everyone you possess. Your stock doubles overnight.

The reverse stock split is aimed to increase the company's share price and lower the number of outstanding shares, which helps firms avoid delisting (such as Nasdaq).

December 5 is the reverse stock split date. The company's shares will have a reduced price and a new CUSIP number, like an ISBN. If you hold GE stock before the reverse split and sell it after that, you'll still have one share, but it will be worth half as much as before.

Why Do Companies Do Reverse Stock Splits?

There are numerous reasons why a company might go forward with a stock split:

• Attract Big Investors: The purpose of reverse stock split is to enable many institutional investors and mutual funds that have restrictions prohibiting holding positions in a stock whose price is below a minimal value, to invest in the company. These companies issue a reverse stock split to achieve this threshold. Even if a firm is not at risk of being delisted by the exchange, its reputation and trading liquidity suffer if it is not eligible to be purchased by such substantial investors.
• Minimum Stock Price: There are stringent listing requirements for minimum share price and share count on several stock exchanges. Companies announce reverse stock splits whenever their share price approaches certain delisting thresholds in order to spare themselves the public humiliation and negative impact on investor sentiment.
• Boost spinoff price: Reverse splits can also be used by companies aiming to create and list a spinoff; i.e, a separate entity formed via the sale or distribution of new shares of an existing business or division of a parent company. For instance, it can be challenging for a corporation considering a spinoff to price the shares of the spinoff company at a higher price if its shares are selling at lower levels. By reverse splitting the shares and raising the price at which each share trades, this problem can be resolved.

Conclusion

The management chooses whether to do a forward stock split or a reverse stock split. An investor cannot choose whether to comply with or object to a reverse stock split. However, since reverse stock splits are essentially an accounting tactic, you shouldn't be concerned about them as long as your investments are in fundamentally sound businesses. Reverse stock splits don't result in any monetary gain or loss. Reverse splits, however, are frequently seen negatively since they signify a company's share price has fallen sharply, perhaps placing it at risk of being delisted. Some retail investors who prefer equities with lower sticker prices may find the higher-priced shares as a result of the split to be less appealing.