A Beginner's Guide to Reversed Stock Splits (And Why it's Not a Magic Trick)

Stock splits can be beneficial for stockholders, but there is a special type of stock split that can have an even bigger impact. That’s reverse stock splitting

WORDS BY
Zoe Burt
Published
January 19, 2024
There's stock split, then there's reverse stock splits. But it's not all as complicated as you might think (Image: Female Invest)
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Investing
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They say that the world of finance can be full of jargon, and boy is the phrase a reverse stock split a mouthful. But what actually is this phenomenon and why would a company want to do it? Well actually, it’s a tool used by companies to seduce potential investors into purchasing stock and by savvy investors who want to maximize their return on investment. The word sounds like something out of a sci-fi movie, but it’s actually a very common financial term you need to know. 

What is a reverse stock split?

Owning shares that have undergone a reverse stock split can be exciting. Unlike other splits, reverse stock splits don’t cause investors to own more shares and increase their holdings, but rather result in owning fewer shares with higher prices.  Also known as stock consolidation, stock merge or even share rollback, reverse stock splits involve taking the current number of existing shares of a certain type of stock and reducing them into fewer but higher-priced units. For example, if a reverse split is 1-for-5 then that means for every five stocks you own you'll now have just one - but it will be worth five times more than before. With reverse splits, your investments can soar quick.

Understanding reverse stock splits

A reverse stock split can be a great way to increase the value of your stock. It works by having a company reduces the number of outstanding shares, making each share worth more money so investors are encouraged to purchase them.

For example, if they have 10 million shares outstanding before the split, after the split they may only have 5 million shares outstanding. This can be done in order to increase the share price or make the company look more attractive for potential investors. 

Think of stock splits like pizza - you're just dividing it into additional slices without changing the overall value (Photo: Tamas Pap/Unsplash)


It's important to note that when a company does this, their market capitalization (the total value of their outstanding shares) stays the same. So if they had 10 million shares at £5 each before the split, afterward they would have 5 million shares at £10 each. The total value (market capitalization) would remain at £50 million in both cases. 

Why do companies issue reverse stock splits?

Companies may choose to do a reversed stock split for several reasons. The primary reason is often that they want to increase their share price in order to appear more attractive for investors or institutions looking to purchase large amounts of their stock. For example, if a company has 1 million shares trading at £1 each (£1 million market cap), it may be difficult for an institution or mutual fund manager to buy enough of them without significantly affecting the share price. By doing a reverse stock split and reducing those 1 million shares down to 100 thousand (£10 per share), there will be less chance of driving up prices when buying and selling large amounts of stock. 

Reversed stock splits are usually done as a way to boost investor confidence and/or increase the share price. For example, if a company has an extremely low share price (say £0.20), investors may be hesitant to buy it because it looks like it isn’t doing too well. By doing a reverse stock split, the company can make each of their existing shares more valuable. So now instead of having 100 shares at £0.20 each, they have 10 shares at £2 each—much more appealing for potential investors! 

This does come with some risks though. When companies issue reverse stock splits, they're essentially manipulating their own market prices which can lead to accusations of insider trading or other shady practices. So if you ever come across one of these splits make sure you do your research first and understand what is going on before investing any money in the company! 

Pros and cons of a reverse stock split

Like anything in the investing world, reverse stock splits come with their own set of pros and cons. So what are they?

Pros

  • Attractive prices: Reverse stock splits often make stock prices more attractive to bigger institutional investors such as mutual funds, since stock prices below a certain amount won't be considered when they decide what stocks to purchase.
  • Boost liquidity: In a reverse stock split, investors may find that there is an increase in stock prices which creates a more attractive stock for potential buyers and helps enhance trading liquidity.

Reversed stock splits signal the success of a company.

  • Greater visibility: It can help create greater visibility for the stock, intensifying its presence among major stock indexes like the Dow Jones Industrial Average or NASDAQ's Composite Index. 

So as you can see, reverse stock splits don't have to be a bad thing - in fact they can help pave the way for profitability and success.

Cons

  • Increased stock price: A reverse stock split reduces the number of shares owned by stockholder but also results in a corresponding increase in stock price. This can be especially detrimental for small investors who are left with fewer shares and greater financial risks.
  • Reduce liquidity: In some cases, the stock becomes less liquid due to fewer shareholders, which can result in decreased market growth and potentially, higher prices for the stock.
  • Harming investor confidence: Although companies may complete a reverse stock split to boost investor sentiment, it could backfire and have the opposite effect. It could signal the company is struggling and some larger shareholders might choose to sell their holdings after the split if it does not match their strategic objectives.

So, while stock splits may have advantages in some cases, it's important for investors to evaluate all aspects before investing their hard-earned money.

Is a reverse stock split good or bad for investors? 

When most investors hear about a reverse stock split taking place in a company they own shares in, they immediately assume that it’s bad news for them - but that isn’t necessarily true. In some cases, reverse splits can be beneficial for existing investors as well as potential new ones. After all, no one likes buying into a company whose share price looks too low to be real. That being said, there are also risks associated with investing in companies that have recently undergone reverse splits. These include reduced liquidity and increased volatility due to fewer available shares on the market. 

Stock splits are designed to make shares more alluring to potential buyers (Photo: Mackenzie Freemire/Unsplash)


Real-life example of reverse stock splits

Many major companies view stock splits as advantageous, and a good example of this is Netflix in 2015. The company opted to go through with a reverse stock split, where existing shares were converted into a smaller amount of more valuable stock. The result was a stock price increase of nearly 300%, giving stockholders huge returns – and inspiring other companies to consider the advantages of stock splits. Investors saw the benefit of the fluctuation when Netflix's stock doubled within the next two years! This real life example demonstrates that stock splits are not only feasible, but can provide significant rewards while freeing up cash in the process.

In January 1999, Amazon also split their stock 3-for-1, meaning that each stockholder got three shares of stock for every one share they previously owned. This allowed existing stockholders at the time to benefit from increased liquidity and decreased volatility. It's important to really understand the many advantages that stock splits bring to gain the most out of your stock investments!

Stock splits vs reversed stock splits

When it comes to stock splitting, you may wonder what the difference is between a reverse split and a traditional stock split. A reverse stock split occurs when the company reduces its number of shares while maintaining their overall value. For example, if a company offers a reverse split of 1-for-10, this means that the ten shares are converted into one share with the same overall value. Meanwhile in a traditional stock split, shareholders’ holdings are increased due to an increase in their number of shares - for instance, 2-for-2 or 3-for-2 splits - without any alteration to their underlying value. Ultimately, it's important to consider both reverse and traditional stock splits as they each bring different effects to the market and can help determine where your investment stands in the long run.

Reverse stock splits don’t cause investors to own more shares and increase their holdings, but rather result in owning fewer shares with higher prices (Image: Female Invest)

As a stock investor, understanding the subtle differences between reverse and traditional stock splits is essential to making informed decisions. A reverse stock split is the rarer of the two options, but just as impactful. It involves a reduction in a company's shares outstanding with an equivalent proportionate increase in price per share. Think of reverse stock splits like reverse ageing -it shrinks your physical presence drastically while also making you look and feel younger in an instant. On the other hand, standard stock splits are like classic ageing - more gradual and happening over a longer period of time. With regular stock splits, investors see an increase in shares outstanding with a corresponding decrease in the stock’s price. Knowing these differences will help ensure that you make smart investing moves no matter how good or bad the market looks!

What happens if shares I own undergo a reverse stock split?

Owning shares that have undergone a reverse stock split can be exciting. Unlike other splits, reverse stock splits don’t cause investors to own more shares and increase their holdings, but rather result in owning fewer shares with higher prices. During a reverse stock split, the number of outstanding shares is decreased proportionally while the share price rises in an inverse direction. This does not cause investors to lose value as it essentially represents consolidation of existing investments and resources. Plus, reverse splits can often signify that a company is about to grow, which can make them attractive to potential investors – good news for savvy owners who want to capitalise on reverse splits.

Who actually benefits from a reverse stock split?

The simple is answer is this: both companies and individual investors themselves. For example, it can help companies rise from the depths of a bear market and gain investor trust, helping propel their stock prices to greater heights. It can give investors a fresh chance to get into the market, and catch it in its early stages of a push upwards. And reverse splits often avert delisting for major exchanges, such as the NYSE or NASDAQ, ensuring continued confidence among traders. In short, reverse stock splits are often well worth considering for the benefits they could potentially offer both the company performing it and investors getting in on it.

Can you make money from reverse stock splits?

A reverse stock split isn’t usually a get-rich-quick ploy, but it could lead to greater rewards for savvy investors. In some cases, reverse splits can increase investor confidence and potentially boost the price of a stock as more investors take interest and snap up shares. Unfortunately, reverse stock splits may also decrease investor confidence in the company if it's seen as a sign of weakness or inability to keep up with the market trends. Before deciding how to invest, consider the potential consequences carefully.

The bottom line

At first glance, a reversed stock split may seem intimidating and confusing, but it doesn't have to be. With this basic understanding under your belt, you can confidently talk about stocks with other investors and sound like you know exactly what you are talking about! Whether you are just getting started investing or already own some stocks, understanding reversed splits can help boost your confidence as an investor and ensure that you make smart decisions with your money. So don't be afraid - embrace reversed splits with confidence! Now go forth and invest fearlessly!

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Investing

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