When companies elect to perform a reverse stock split, it might seem to provide certain signals to shareholders. Although reverse stock splits don’t impact the actual market capitalization of a publicly traded company, they impact the share price and the number of shares outstanding.
A stock split and a reverse stock split are both corporate actions that company leadership might choose due to several reasons including market conditions or changes in the company's health. A reverse stock split might be viewed as a signal to sell if it goes along with prior indicators that the company isn’t performing well.
What is a stock split?
In order to understand a reverse stock split, it's useful to first know what a stock split is. When a stock split occurs, a company increases its number of outstanding shares but decreases the value of each share proportionately.
A reverse stock split does the opposite of a stock split. A firm divides the number of shares each investor holds, which causes the price per share to increase. For example, a 1-for-5 reverse stock split merges every five existing shares into a single new share. The price would be multiplied by five.
In both stock splits and reverse stock splits, the total market capitalization of a company doesn't change. The share price of a stock increases in the case of reverse stock splits.
Why companies perform reverse stock splits
There are several reasons a company might decide to do a reverse stock split. Analysts often view this step as a red flag that the company is struggling.
A common reason for a reverse stock split is that the company has dropped in share price to a dangerously low level. For example, the New York Stock Exchange might delist a company from its exchange if the share price closes below $1 for 30 consecutive trading days.
If a company is approaching that threshold, a reverse stock split immediately multiplies the share price as the number of shares decreases.
Another possible reason for a reverse stock split is that the company wants to attract bigger investors who have a minimum price threshold. The company's liquidity can be harmed if it doesn’t qualify for purchase by institutional investors.
A reverse stock split could also be a strategy to help gain investors when a parent company is planning a spin-off. Increasing the share price of the original company could help smooth the process of spinning out another company.
When a reverse stock split isn’t a selling signal
It’s possible that a company could initiate a reverse stock split in conjunction with positive changes like improved operations or changes in leadership. If a reverse stock split is accompanied by fundamental improvements to the firm, the higher share price might remain long term, which makes the stock a good investment.
Remember that a reverse split doesn't affect the value of shares of a stock. It only affects the ratio of how your equity is assessed. So, if investors are deciding whether to buy or sell shares based on news of a reverse stock split, they need to consider other aspects besides the split.