A stock split allows companies to increase the number of shares offered to investors, without changing shareholder equity. Rather than issuing new shares, companies may split stock to reduce prices.
A reverse stock split can be used to condense and combine stock shares. This type of stock split is often done to increase share prices.
While a reverse stock split can improve a stock’s price in the near term, it could be a sign that a company is struggling financially. Large fluctuations in stock pricing associated with a reverse stock split could also cause investors to lose money.
For investors who are concerned about managing risk inside their investment portfolio, it’s important to understand how a reverse stock split works, along with the pros and cons.
What Is a Reverse Stock Split?
A stock split increases the number of shares available to trade without affecting an investor’s equity stake in those shares. For example, if you own 100 shares of XYZ stock and the company initiates a two-for-one split, you’d own 200 shares of stock once it’s completed. At the same time, the stock’s price would be cut in half. So if your shares were worth $100 before, they’d be worth $50 each afterward.
A reverse stock split moves in the opposite direction. Companies can use different ratios for executing reverse stock splits. For example, a company could decide to initiate a reverse split that converts every 10 shares of stock into a single share. So if you owned 100 shares before the reverse split, you’d own 10 shares afterward.
The stock’s price would also change proportionately. So if each share of stock was valued at $10 before the split, those shares would be worth $100 afterward. Your overall investment would still be valued at $1,000; the only thing that changes is the number of shares you own.
Why Do Companies Execute Reverse Stock Splits?
There are different reasons why a company may choose to execute a reverse stock split. Most often, it’s used as a tool for increasing the share prices of stock.
Raising stock prices is a tactic that can be used to attract new investors if the company believes the current trading price is too low. A higher share price could send a signal to the market that the company is worth investing in. Companies may also choose to reverse split stocks to meet minimum bid price requirements in order to stay listed on a major stock exchange.
Reverse stock splits don’t affect a company’s market capitalization, which represents the total number of a company’s outstanding shares multiplied by its current market price per share. But by consolidating existing shares into fewer shares, those shares can become more valuable.
Do You Lose Money on a Stock Split?
Avoiding losses is part of investing strategically, and it makes sense if investors wonder how a forward stock split or a reverse stock split could impact them financially.
A stock split itself doesn’t cause an investor to lose money, because the total value of their investment doesn’t change. What changes is the number of shares they own and what each one of those shares is priced at.
For example, if you have $1,000 invested before a forward stock split or a reverse stock split, you would still have $1,000 afterward. But depending on which way the stock split moves, you may own more or fewer shares and the price of those shares would change correspondingly.
If you own a stock that pays stock dividends, those dividend payments would also adjust accordingly. For instance, in a forward two-for-one split of a stock that’s currently paying $2 per share in dividends, the new payout would be $1 per share. If you own a stock that pays $1 per share in dividends, then undergoes a reverse stock split that combines five shares into one, your new dividend payout would be $5 per share.
Is a Reverse Stock Split Good or Bad?
Whether a reverse stock split is good or bad can depend on why the company chose to initiate it and the impacts it has on the company’s overall financial situation.
At first glance, a reverse stock split can seem like a red flag. If a company is trying to boost its share price to try and attract new investors, that could be a sign that it’s desperate for cash. But there are other indicators that a company is struggling financially. Poor earnings reports or a diminishing dividend could also be clues that a company is underperforming.
In terms of outcomes, there are two broad paths that can open up following a reverse stock split.
A Reverse Stock Split Could Create Opportunities
Path A creates new opportunities for the company to grow and strengthen financially, but this is usually dependent on taking other measures. For example, if a company is also taking steps to reduce its debt load or improve earnings, then a reverse stock split could yield long-term benefits with regard to pricing.
A Reverse Stock Split Could Result in Losses
On the other hand, Path B could result in losses to investors if the new price doesn’t stick. If stock prices fall after a reverse stock split, that means an investor’s new combined shares become less valuable. A Path B scenario may be likely if the company isn’t making other efforts to improve its financial situation, or if the efforts they are making fail.
Should I Sell Before a Stock Split?
There are many factors that go into deciding when to sell a stock. Whether it makes sense to sell before a stock split or after can depend on what other signs the company is giving off with regard to its financial health and how an investor expects it to perform after the split.
Investors who have shares in a company that has a strong track record overall may choose to remain invested. Even though a split may result in a lower share price in the near term, their investments could grow in value if the price continues to climb after the split.
With a reverse stock split, a decision to sell (or not sell) may hinge on why the company is executing the split. If a reverse stock split is being done to raise prices and attract new investors, it’s important to consider what the company’s goals are for doing so.
Taking a look at the company’s finances and comparing things like price to earnings (P/E) ratio, earnings per share (EPS) and other key ratios that may be gleaned by reading the company’s earnings report, can give you a better idea of which direction things may be headed.
A reverse stock split itself shouldn’t impact an investor—their overall investment value remains the same, even as stocks are consolidated at a higher price. But the reasons behind the reverse stock split are worth investigating, and the split itself has the potential to drive stock prices down.
Stock splits are something investors may encounter from time to time. Understanding what the implications of a forward or reverse stock split are and what they can tell you about a company can help an investor develop a strategy for managing them.
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