What Is a Reverse Stock Split?

A reverse stock split is a type of corporate action that consolidates the number of existing shares of stock into fewer (higher-priced) shares. A reverse stock split divides the existing total quantity of shares by a number such as five or 10, which would then be called a 1-for-5 or 1-for-10 reverse split, respectively. A reverse stock split also is known as a stock consolidation, stock merge, or share rollback and is the opposite of a stock split, where a share is divided (split) into multiple parts.

Understanding Reverse Stock Splits

Depending on market developments and situations, companies can take several actions at the corporate level that may impact their capital structure. One of these is a reverse stock split, whereby existing shares of corporate stock are effectively merged to create a smaller number of proportionally more valuable shares. Since companies don’t create any value by decreasing the number of shares, the price per share increases proportionally.

Per-share price bumping is the primary reason why companies opt for reverse stock splits, and the associated ratios may range from 1-for-2 to as high as 1-for-100. Reverse stock splits do not impact a corporation's value, although they usually are a result of its stock having shed substantial value. The negative connotation associated with such an act is often self-defeating as the stock is subject to renewed selling pressure.

Advantages and Disadvantages of Reverse Stock Splits

There are several reasons why a company may decide to reduce its number of outstanding shares in the market, some of which are advantageous.

Advantages

Prevent major exchange removal: A share price may have tumbled to record low levels, which might make it vulnerable to further market pressure and other untoward developments, such as a failure to fulfill the exchange listing requirements.

An exchange generally specifies a minimum bid price for a stock to be listed. If the stock falls below this bid price and remains lower than that threshold level over a certain period, it risks being delisted from the exchange.

For example, Nasdaq may delist a stock that is consistently trading below $1 per share. Removal from a national-level exchange relegates the company's shares to penny stock status, forcing them to list on the pink sheets. Once placed in these alternative marketplaces for low-value stocks, the shares become harder to buy and sell.

Attract big investors: Companies also maintain higher share prices through reverse stock splits because many institutional investors and mutual funds have policies against taking positions in a stock whose price is below a minimum value. Even if a company remains free of delisting risk by the exchange, its failure to qualify for purchase by such large-sized investors mars its trading liquidity and reputation.

Satisfy regulators: In different jurisdictions across the globe, a company’s regulation depends upon the number of shareholders, among other factors. By reducing the number of shares, companies at times aim to lower the number of shareholders to come under the purview of their preferred regulator or preferred set of laws. Companies that want to go private may also attempt to reduce the number of shareholders through such measures.

Boost spinoff prices: Companies planning to create and float a spinoff, an independent company constructed through the sale or distribution of new shares of an existing business or division of a parent company, might also use reverse splits to gain attractive prices.

For example, if shares of a company planning a spinoff are trading at lower levels, it may be difficult for it to price its spinoff company shares at a higher price. This issue could potentially be remedied by reverse splitting the shares and increasing how much each of their shares trades for.

Disadvantages

Generally, a reverse stock split is not perceived positively by market participants. It indicates that the stock price has gone to the bottom and that the company management is attempting to inflate the prices artificially without any real business proposition. Additionally, the liquidity of the stock also may take a toll with the number of shares getting reduced in the open market.

Example of a Reverse Stock Split

Say a pharmaceutical company has 10 million outstanding shares in the market, which are trading for $5 per share. As the share price is lower, the company management may wish to artificially inflate the per-share price. It decides to go for the 1-for-5 reverse stock split, which essentially means merging five existing shares into one new share. Once the corporate action exercise is over, the company will have two million new shares (10 million / 5), with each share now costing $25 each ($5 x 5).

The proportionate change in share price also supports the fact that the company has not created any real value simply by performing the reverse stock split. Its overall value, represented by market capitalization, before and after the corporate action should remain the same.

The previous market cap is the earlier number of total shares times the earlier price per share, which is $50 million ($5 x 10 million). The market cap following the stock merger is the new number of total shares times the new price per share, which is also $50 million ($25 x 2 million).

Real-World Example

In 2002, the largest telecommunications company in the U.S., AT&T Inc. (T), performed a 1-for-5 reverse stock split, in conjunction with plans of spinning off its cable TV division and merging it with Comcast Corp. (CMCSA). The corporate action was planned as AT&T feared that the spinoff could lead to a significant decline in its share price and could impact liquidity, business, and its ability to raise capital.

Other regular instances of reverse stock splits include many small, often non-profitable companies involved in research and development (R&D), which do not have any profit-making or marketable product or service. In such cases, companies undergo this corporate action simply to maintain their listing on a premier stock exchange.

The Bottom Line

When a publicly traded company consolidates shares, this is known as a reverse stock split or sometimes as stock consolidation, a stock merge, or a share rollback. The consolidation has no impact on a company's value. For example, if five million shares are trading at $10 per share, a 1-for-5 reverse split would result in one million shares trading at $50 per share. Reverse stock splits often are viewed negatively since it often is a means of inflating a stock's price without increasing the value of the company.