An investor should be aware of the subtleties of the stock market. Just like in many financial moves, reverse stock splits are also frequently overseen. however, those decisions by a company can drastically affect the real shareholders. In this article, we’ll outline 5 basic insights about reverse stock splits, how they function, and their implications for your money. Additionally, we’ll use a real-life case study to give a better insight into this concept.
What is a reverse stock split?
A reverse stock split is that corporate action by which shares are consolidated so as to reduce the number of outstanding shares in the course of increasing the price per share. For instance, assuming a 1-for-10 reverse stock split, if you hold 100 shares priced at $1 each, after the reverse split, you end up with 10 shares priced at $10 each. The bottom line will still be the same; only the number of shares and their values are changed.
Why Do Companies Engage in Reverse Stock Split?
There are numerous reasons why an organization may opt to undertake a reverse stock split of the stocks, including the following.
Recover Listing Compliance The NASDAQ or NYSE stocks are often at risk of being delisted if they are traded below a specified price, especially below $1. A reverse stock split will assist the firm to achieve the minimum share price thresholds and thus avoid a delisting.
Improve Investor Perception On the whole, a higher-priced stock gives the company a feel of stability or health, thereby making it more enticing to institutional investors. The fundamentals of the company have not changed, but the psychological impact can sometime stabilize the stock.
Facilitate Mergers or Acquisitions If a company is aiming at merging or acquiring another company, the higher-priced stock serves as leverage in the negotiations with a better term of acquisition.
As a result, firms can attract institutional investors with funds that have minimum price thresholds to purchase shares. The companies have a higher chance of increasing their investor base by reversing the split if their share prices do not meet the requirements of institutional and mutual funds.
Sometimes, the company may need to restructure its capital. A reverse stock split can help raise more capital as it reduces volatility and increases investor confidence sometimes.
How Do Reverse Stock Splits Work?
The mechanics of a reverse stock split are straightforward. The company will announce the split ratio, perhaps 1-for-5 or 1-for-10, and the effective date. Shareholders’ total value is unchanged—but the number of shares and their price adjust the difference. For example:
Pre-Split You have 200 shares at $2 apiece.
Post 1-for-5 Reverse Split You have 40 shares at $10 each.
As share counts decline, the net market value of your shares remain unchanged save for the fluctuation of the market.
Case Study Citigroup’s 1-for-10 Reverse Stock Split of 2011
Citigroup undertook a reverse stock split in 2011 that was significant enough. The share had already fallen to as low as $1 due to the financial crisis of 2008. In its quest to increase the price of its stock and improve the image of the company on Wall Street, Citigroup affected a 1-for-10 reverse stock split.
Result
Before the split, shares of Citigroup were trading at around $4.50 per share
After the split, prices shot up to around $45 per share.
The company also regained compliance with the minimum price requirements of the New York Stock Exchange.
But reverse stock split was no magic pill for Citigroup. Although increased stock price made investors happy at least for the short term, but a lot of fundamental issues of the company, such as legacy mortgage losses and earnings, remained unchanged. With time, stock performance of Citigroup remained miserable compared to the other firms.
Citigroup’s case key takeaways
Short-term versus long-term impact A reverse stock split can have the short-term benefit of stabilizing the stock price but will not help in dealing with the underlying business problems.
Investor Sentiment A higher share price does attract investors but does not alter the fundamentals of the company’s financials.
Risk of Further Decline Citigroup’s stock continued to stay volatile even after the split, and many commentators feel reverse splits only cause more problems for companies struggling in the space.
Conclusion
The potentials of a reverse stock split are considerable.
Even with the advantages of reverse splits, there is no guarantee that it is totally risk-free. Investors can view a reverse split as an indication that a company is not doing very well. Here are some common concerns:
PERCEPTION OF FINANCIAL WEAKNESS
Reverse splits happen so often as an indication of financial stress in a company that investors view this action poorly.
Reduced liquidity. With fewer shares floating on the market, the stock might experience reduced liquidity, and this could possibly increase the price volatility following the reverse stock split.
Psychological Impact Naysayers will tend to sell out due to fear and uncertainties triggered by the reverse stock split, thus pushing the stock price even lower.
DOES A REVERSE STOCK SPLIT AFFECT SHAREHOLDERS?
The shares held by existing shareholders have no altered value from immediately following the reverse split. Still, depending on corporate healthiness in financial, the effects may appear with more significant long-term effects. Here’s what to consider:
Stock price stability Stocks can stabilize at first after a reverse split, though it does not guarantee success in the long run.
Stock price appreciation might also occur if reverse stock splits are in the package of a larger restructuring or growth plan.
Putting it All Together
Reverse stock split would involve company strategies that have positive effects on shareholders and the company’s stock price alongside negative implications. It is usually done as the last resort to avoid a company’s stock from delisting or to improve the reputation of a company, and this strategy does not cure the operating problem a business may be facing.
The investors should focus away from the cosmetic appearance of a reverse stock split, looking deeper into company fundamentals. A split may double the stock’s price for them- that’s nice. However, it is integral to understand whether the firm has a good footing in financial terms. Reverse stock splits can work as a helpful tool in stabilizing the companies’ stock prices; however, in such matters, they should be looked at within a comprehensive financial context.
Conclusion Is a Reverse Stock Split a Red Flag?
A reverse stock split may be a red flag but not under every circumstance. Rather, in certain situations, it’s calculated for better perception and for the company to comply with the requirements demanded by the stock exchange. As an investor, proper due diligence has to be done on the overall health of the company coupled with its long-term strategy before arriving at any investment decision.
In any case, this reverse stock split may be viewed as an opportunity to reassess one’s position and determine whether the future outlook of the company somehow aligns with your investment goals.