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What Is a Reverse Stock Split?
A reverse stock split combines multiple lower-value stocks into a single stock that costs more money per share. This consolidation is the opposite of a traditional stock split, which is sometimes called a forward split. Reverse stock splits increase a company's stock price on a stock exchange. As an example, in a 1-for-8 reverse stock split, every eight existing shares of stock get merged into a single share that costs eight times as much money to buy on the stock market. While the new shares cost more than the old ones, the company's market capitalization will not change, and existing shareholders will neither gain nor lose money.
3 Reasons for a Reverse Stock Split
There are a few common reasons why a company's board of directors might wish to execute a reverse stock split and produce fewer shares of a company.
- Prestige: Businesses sometimes execute reverse stock splits to improve the prestige of their company. For instance, penny stocks can sometimes be more appealing to institutional investors if they are merged into stocks with a much higher share price.
- Stave off delisting: Some stock exchanges have minimum price requirements for listed stocks and funds. When a company's market price plunges, it may need to consolidate its shares to stay listed on one of Wall Street's major exchanges like the Nasdaq or the New York Stock Exchange (NYSE).
- Attract mutual funds and ETFs: Many stocks gain market value when they are purchased en masse by a mutual fund or exchange-traded fund (ETF). The institutional investors who run these funds often take notice of stocks with higher prices. With this in mind, some companies consolidate a large number of outstanding shares into a smaller number to lure these funds.
Reverse Stock Split vs. Forward Stock Split: What’s the Difference?
There are four key distinctions between a forward stock split and a reverse stock split.
- The number of company shares: A forward stock split is a maneuver wherein a publicly traded corporation splits existing shares of stock into smaller, less valuable shares. In doing so, the company increases the number of shares available and lowers the stock price of a single share. Reverse stock splits do the opposite, decreasing the number of company shares. A reverse stock split combines multiple lower-value stocks into a single stock that costs more money per share.
- Long-term vs. short-term goals: While traditional stock splits create more shares and reverse stock splits create fewer shares, neither changes the short-term market cap of a company. The overall value doesn’t change because the new shares have the same total value as the shares they replaced. However, in the long term, forward stock splits tend to produce more incoming capital than reverse splits because they create lower-priced shares that appeal to new investors on a budget. Companies that perform a reverse stock split may be fulfilling a short-term need to stay listed on a stock exchange.
- Frequency of use: In stock trading, forward splits are a more common occurrence than reverse splits. A healthy company usually sees its share price steadily increase, which can precipitate the need for a stock split. Companies that consolidate shares in reverse stock splits tend to be reacting to bad news from the markets.