What is a reverse stock split?

A reverse stock split is an action initiated by a company to reduce the amount of existing shares of stock into smaller (higher-priced) shares. A reverse stock split, also known as a 1-for-5 or 1-for-10 reverse split. A reverse stock split, which is the opposite of a stock split, in which a share is divided into many parts, is also referred to as a stock consolidation, stock merger, or share rollback.

Reverse Stock Split Explained

Companies can adopt a number of corporate actions that may have an influence on their capital structure in response to market trends and conditions. One of them is a reverse stock split, in which existing company stock shares are essentially combined to produce a lower number of shares that are proportionally more valuable. Companies don't add value by reducing the number of shares outstanding, thus the price per share rises proportionately.

Companies can lower the number of outstanding shares in the market by implementing a reverse stock split.

A corporation may announce a reverse stock split in an attempt to raise the price at which its shares are traded, such as when it perceives the price is too low to draw in investors or in a bid to once again meet the minimum bid price criteria of the exchange on which its shares are traded. Small shareholders may be "cashed out" (get a proportional amount of the money in place of partial shares) in some cases, which results in their loss of ownership of the company's shares. In the wake of reverse stock splits, trade prices may fluctuate, causing investors to lose money.

Every outstanding share of a corporation is reduced to a fraction of a share when a reverse stock split is completed. For instance, if a business announces a one-for-ten reverse stock split, every ten of your shares will be changed into one share. Before the reverse stock split, if you owned 10,000 shares of the corporation, you would now hold 1,000 shares overall.

The overall market capitalization of the company remains unchanged after a reverse stock split is implemented, meaning that it has no inherent impact on the company's value. Although the corporation has fewer outstanding shares, the reverse stock split directly improves the share price.

Reasons for a reverse stock split

There are a variety of factors that could influence a company's decision to carry out a reverse stock split and lower the number of outstanding shares on the market. 

1. Avoid being delisted from an exchange: Stocks that are subject to minimum share price regulations face the risk of being delisted from stock exchanges if their price falls below $1. A large exchange listing is necessary to draw equity investors, and in some situations, increasing share values through reverse stock splits is the only way to avoid dismissal.

2. Improve the company's reputation if the stock price has fallen significantly: Particularly if the price is close to $1 or the stock is seen as a penny stock by investors, a stock that is trading in a single digit is probably seen as a risky investment. Penny stocks that are solely traded over the counter (OTC) have a bad reputation, therefore often engineering a reverse stock split is the easiest way to shed this affiliation and save a company's reputation.

3. Gain the attention of key investors and analysts: Stocks with higher prices are more attractive to market analysts, and a positive analyst opinion is beneficial for a company's business. In addition, they are more likely to get the attention of large institutional investors and mutual funds, many of whom have policies prohibiting them from investing in stocks whose price is below a set level.