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Understanding a Reverse Stock Split

Stock splits or Forward Stock Split are good news for investors as the company decides to increase the number of shares increasing the number of shares owned by each investor. And on the other hand is reverse stock split. A reverse stock split is the management’s decision to reduce or merge the existing number of shares increasing the face value and price of the stock.

A reverse stock split is done in a specific ratio i.e. 1:10 (1-for-10), 1:20 or even 1:100. Companies don’t follow any fixed ratio. This means that in a 1:10 split, the price of one share after the split will be equal to the price of 10 shares before the split. Let us suppose you owned 10 stocks of $10 before a reverse split. After this, you will own one share of the same price value.

You can understand how the reverse stock split works in a better way with the help of an example. Consider the company XYZ has announced a reverse stock split of 1:10. Before that XYZ was trading at $1 per share and after the announcement it begins to trade at $10 per share. Now, if you previously own 1000 shares of XYZ this will become 100 shares because of the rise in face value. But, the account value before and after the reverse stock split remains the same.

 
BEFORE
AFTER
StockXYZXYZ
Price$1$10
Shares1000100
Value$1,000$1,000

Why does a Company perform a Reverse Stock Split?

Reverse stock split provides some amount of benefit to the company, and it can do it for many reasons. But more often than not, a reverse split is not considered a good sign among investors. MotleyFool says that a common reason to perform a reverse split is to avoid getting delisted from the market. Major markets have a pre-defined minimum price that companies have to abide to avoid getting delisted. A reverse split in this case helps in appraising the price of a company’s stocks.

Many-a-times, companies face a drastic drop in their stock prices and start trading in single digits. This hinders their reputation and investors consider the company as a risky investment. Also, single-digit priced stocks are claimed as penny stocks and there is a negative stigma attached to it. At this point, a reverse split is an efficient strategy that a company can apply to save itself from any more harm.

A reverse stock split also helps in gaining popularity among investors and analysts. According to Investopedia, higher priced stocks attract attention from analysts and work as an excellent marketing strategy for companies. It is likely that the company will pop-up on radars of big-institutional investors and mutual funds.

Another reason for a reverse split is that it can be the last hope of extending the life of a shrinking company. As in some exceptional cases, companies have made a U-turn and reverse the situation. It is also the reason investing in the companies performing a reverse split is considered risky.

Is the reverse split good or bad?

It is natural for an investor to ponder — why the reverse stock split? Is it a good sign or a bad sign? It is simply a consolidation of a few stocks with no other significant change. Sometimes, companies use it strategically with a specific goal in their mind. It also helps them to buy some time to recover from any trouble they may be facing.

Despite the eventual success stories, a reverse stock split has a negative connotation in the market. One reason is that it shows that the company is in a grave situation. It shows that the company’s management is trying to artificially inflate its price. Even though a reverse stock split changes nothing in the company, it changes the perspective of an investor regarding the company.

That is why as an investor it is important that you study the financials of a company thoroughly before investing. Studying the fundamentals will help you gauge if the split will benefit the company going ahead.


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