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The Reverse Stock Split: What you Need to Know

RagingBullRagingBull ·

What really is a reverse stock split and how does it differ from the “regular” stock split? In this article, we will get to know everything about them. We’ll see the advantages and shortcomings and how you, the investor, stands to benefit.

You’ll find the term used a lot in the corporate restructuring space. Our community sometimes looks for stocks with upcoming reverse stock splits. This is because these might serve as a catalyst for a breakout trade.

Let us begin by first understanding stock splits and how our reverse stock splits differ from these.

stock price ticker

Understanding Stock Splits: The “Regular” Version

It is imperative to first understand what “outstanding” shares are. Each company has some outstanding shares. These stand for the stocks that are traded in the open market. Such shares include the shares in possession of institutional investors and company officials as well. The number of outstanding shares varies based on many factors. It can both increase and decrease.

Every publicly traded company has its own share of outstanding shares. When a company undertakes a stock split, the number of outstanding shares is increased. This is done by “splitting” the shares, i.e., issuing additional shares to the current shareholders.

Let us take a 2-for-1 stock split for example. Each shareholder’s shares are effectively doubled. But, as you might have guessed, the market capitalization will remain unchanged. The stock price is decreased as the number of outstanding shares increases, though.

What Are Reverse Stock Splits?

Now that we know what stock splits are, let us now proceed to understand reverse stock splits. True to its name, the reverse stock split is a stock split in reverse. They reduce the total number of a company’s outstanding shares. So, there is an increase in the stock price. It does not have a fundamental effect on the company’s market value immediately after.

For example, assume that a company you are invested in conducts a 1-for-5 reverse stock split. Let’s say you owned 1,000 shares of the company. After the reverse split, you would only own 200 shares of the stock, which is simply 1,000 divided by 5.

The price where you owned the stock would be 5 times the price the day before the reverse. So, the market value of the stock position would not change.

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bar graph with trend lines

4 Reasons Why A Company Would Undertake A Reverse Stock Split

Since the market capitalization remains unchanged, why would a company want to perform a reverse stock split? Let us explore some common reasons.

  • Increase share price: The most important reason is evident from the definition of the reverse stock split itself. It’s basically a move to increase the per share price. This is a direct consequence of the fact that the number of outstanding shares has decreased.
  • Avoid delisting on exchanges: Reverse stock splits have become a popular way for companies to avoid being delisted from major stock exchanges. Stock exchanges often have constraints on the minimum stock price. If the latter goes below $1, the company runs the danger of being delisted. For obvious reasons, companies will want to avoid delisting to retain access to equity investors. Performing a reverse stock split will help boost stock prices. This is one way to retain the hold on the stock exchanges.
  • Avoid removal for indices: They also deter removal from major stock indices.
  • Restore positive brand image: It helps to remove some of the negative connotations associated with being a “penny stock.” When a company’s stock trades near or below $1, it can be seen as penny stock. This can affect the way the company’s image is perceived by investors.

Do Reverse Stock Splits Work?

A fundamental question is if they really work. Well, that depends on a variety of factors. Every coin has two sides. Such reverse splits can have both positive and negative implications on the company’s image.

  • Negative image: Most investors understand when a company will perform reverse stock splits. This is usually when it urgently needs to redeem share prices. The latter have fallen so low that the company might be on the verge of getting delisted from the major exchanges. Investors can make out there’s something wrong: the company could be struggling. Thus, the reverse stocks split, in this case, could be perceived as a mere market gimmick.
  • Positive image: The other end of the spectrum is brighter. They can also help the company restore a positive market image. The company can take its stock prices to a respectable level and avoid them being seen as penny stocks. A company with penny stocks traded OTC (Over The Counter) could transition to an organization listed on major exchanges. It will then attract more powerful investors and grow at a much faster pace.

The Pros and Cons of Reverse Stock Splits

We’ve already seen how reverse splits can make or break the brand image. Let us now attempt to understand the major pros and cons of them.

We’ll first see the advantages and benefits that come with the reverse stock split process.

  • Prevents short selling and reduces speculation in prices: When they’re performed, the number of outstanding shares is reduced. This will make it difficult for traders to short sell stocks. The reason is clear: short selling is only feasible with highly liquid stocks. A reverse stocks split will lower speculation factors in the stock price.
  • Increases stock price: The reduction in the number of outstanding shares automatically raises the per share price. Companies battling critically low price levels can redeem their image and restore their share prices with this move.
  • Faster decision-making: A large number of shareholders often translates to slower decision-making. This is because shareholders usually vote in major company decisions. It will also serve to reduce the shareholder base. This means that the decision-making process will be faster and much more efficient. The inherent delays will be eliminated as a direct consequence of the reverse stock split, after all.
  • Attracts positive marketing: A reverse stock split can help a company garner the attention of analysts. This is because stocks that are higher-priced naturally draw in more experts. Analysts are much more likely to speak highly of the company and its stock. This, in turn, will significantly boost business.

Let us now see the challenges and shortcomings associated with them.

  • Reduced liquidity: Reduced liquidity is both a boon and a curse. We saw how it prevents short selling but it also makes the stock less tradeable.
  • Perceived negative brand image: We saw earlier how investors might perceive the reverse stock split move as a redeeming one. They might hold on to the notion of the company struggling to retain its hold in the market. This can alter the company’s value in a negative way.
  • Loss to small investors: Smaller shareholders always stand to lose out when it comes to a reverse stock split. This is because the number of outstanding shares has been reduced. This confines the remaining ones to the major players.
  • Continued decline: Performing one is no guarantee of success. Even though the move is carried out to restore stock price, it has been observed that the price can continue to fall in the aftermath of the reverse split as well.

What investors should look out for and the key reverse stock split examples

Since there is a decrease in the number of outstanding shares, there is a decrease in floating shares. This implies that if there is a high short interest, the stock could potentially squeeze and cause a run up.

Let’s look at some examples of reverse stock splits that have run up after the companies announced one.

For example, Infosonics Corp (IFON) conducted a 1-for-5. Recall that by definition, this divides the outstanding shares by 5. Furthermore, this reduces the floating shares.

That said, with a short interest of 12%, this could squeeze once shorts start covering due to the low number of floating shares, which was just over 500K.

Here’s what happened with IFON:

IFON reverse stock split

Note that these are the split-adjusted prices for IFON. Before IFON’s reverse split, the stock dropped a point before rebounding. The day after, IFON popped over 3 points.

With that in mind, it’s worth it to follow reverse splits to see whether there’s a trade in the stock. If there’s a high short interest and an upcoming reverse split, you might want to keep the stock on your radar for a breakout trade.

Conclusion

Reverse stock splits enable companies to boost their share prices in a bid to secure a firm footing. We saw, however, that the move can result in both a positive image for the brand as well as present significant challenges.

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