A reverse stock split is when a corporation merges its existing shares of stock into a smaller number of shares, which raises their price. It's the opposite of a stock split, when existing stock is split into a greater number of shares.
Find out more about reverse stock splits, how they work, and what they are used for.
What Is a Reverse Stock Split?
In a reverse stock split, each of a company's outstanding shares is converted to a fraction of a share. For example, in a 1-to-10 reverse split, every 10 shares would be merged into one share. If you own 100 shares of a company's stock, and the company declares a reverse stock split, afterward you would have 10 shares.
If a company's share price has fallen steeply, it may fail to meet a minimum stock price, which is one of several criteria required for being listed on a major exchange such as the New York Stock Exchange (NYSE).
In order to avoid the embarrassment and practical disadvantages of being delisted from an exchange, the board of directors of a corporation may declare a reverse stock split to increase the quoted market value of its shares.
In theory, the move is neither good nor bad for stockholders because although the price may appear to change, the relative ownership does not. In practice, however, reverse splits can signal a move to combat depressed prices, which investors may view with a wary eye.
How Does a Reverse Stock Split Work?
To be listed on such an exchange, the corporation must meet several criteria, including a minimum number of round lot holders (shareholders owning more than 100 shares), an absolute number of shareholders, a specific net income threshold, a total number of public shares outstanding, and a minimum stock price.
These requirements are designed to ensure that the common stocks classified as exchange-traded securities are only made up of reputable, respected, financially-viable enterprises.
Meeting the criteria doesn't mean the corporations will be good investments — some still have gone bankrupt, leaving their investors with painful losses — only that the business is large enough to meet the standard of the exchange.
In times of market or economic turmoil, including during a major recession, individual businesses or even entire sectors may suffer a catastrophic decline in the per-share stock price. If the market price falls far enough, the company risks being delisted from the exchange, which is a severe hardship for existing stockholders. For example, companies that trade on the NYSE risk being delisted if their per-share price drops below $1 for 30 days in a row.
To illustrate the concept, assume you own 1,000 shares of Bubble Gum Industries, Inc., each trading at $15 per share. The business hits an unprecedented rough patch, losing key customers. It suffers a labor dispute with workers and experiences an increase in raw commodity costs, eroding profits.
The result is a dramatic decline in the stock price, falling all the way down to 80 cents per share. Long-term, you believe the business will still be fine, but short-term prospects don’t look good.
Management knows it has to do something to avoid delisting, so it asks the board of directors to declare a 10-for-1 reverse stock split. The board agrees and the total number of shares outstanding is reduced by 90%.
You wake up one day, log into your brokerage account and now see that instead of owning 1,000 shares at 80 cents each, you own 100 shares at $8 each. Economically, you are in the exact same position as you were prior to the reverse stock split: you still own $800 worth of company stock. But the company has now bought itself time to improve its business before getting booted from the exchange.
- A reverse stock split is when a company converts its shares into a fraction of a share, effectively merging them.
- Reverse stock splits can be used to boost a stock's per-share price and avoid being delisted from a major stock exchange.
- Reverse stock splits can indicate plummeting per-share prices, which may be worrisome to investors even if the action itself has no true effect on the value of shares owned.