Reasons for a Reverse Stock Split
Companies typically implement a reverse stock split to increase the share price in order to prevent themselves from running afoul of exchanges’ delisting rules. On the New York Stock Exchange (NYSE), for example, if a stock price falls below $1 and does not recover after 30 consecutive days, the company is delisted with six months to fix its share price. The 1:7 reverse gives DryShips a stock price of $6.23 and keeps the firm over its pricing threshold for continued trading (otherwise known as “not-getting-delisted”). Moreover, a boosted stock price can occasionally draw the focus of more institutional investors. Reverse transactions can also help some companies meet the minimum stock price for some investors, thus providing a way to gain or increase institutional ownership.
Impact on Investors
Since a reverse stock split does not change the total level of equity an investor holds — the number of shares * prices per share=$ value, in theory. However, other consequential effects should be addressed! For instance, if a company implements a 1:10 reverse stock split and an investor initially has, say, 1000 shares at $1 per share. Post-split, the investor would possess 100 shares at $10 per share, and the total market value would remain the same at $1,000. Despite that, the facts state that 60% of firms decrease in stock price by up to %5 percent following a reverse split. For instance, when Valeant Pharmaceuticals did a 1:15 reverse split in 2016 its stock was down by over 12% after the very first month and dropped up to -85% within another two years.
Negative Impacts:
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Investor confidence may suffer: If a company has consistently underperformed so that its stock price is now pennies on the dollar, instituting reverse split signals rough seas ahead. Last year, investors didn’t appreciate such rumors when the stock price rapidly fell 5% on news of a reverse split as GE remained in the doldrums.
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Reduced liquidity: The smaller number of shares held means that the interest from small shareholders in the stock will decline, especially if these investors are lured to security by its low price. In the two months following a 1:20 reverse stock split, which increased its share price from $0.70 to $14) in July of 2009, trading volume in AIG dropped by an average of only about 25%.
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Potential for negative returns: A study by the Financial Analysts Journal in 2006 found that within a year after implementing reverse stock splits, as many as 58% of companies experience their share price drop. Especially companies in financial crises huge downward spurts are observed. An example: Once Lehman Brothers reverse-split 1-to-10 in May of 2008, the stock price then lost almost half its value again within three months.
Positive Impacts:
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Maintaining listing qualifications: Proceeding with a reverse stock split briefly raises its share price prior to falling below delisting standards. In 2020, Overstock. Nasdaq-listed e-commerce company with a reverse split up to $0.88 ->$9, and able to continue listing on the main board；
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Attracting institutional investors: Several institutional investors have minimum stock price thresholds, so a reverse split enables the company to qualify for those requirements and gain greater capital support. A 1:5 reverse stock split by Nokia in 2006 lifted its share price from a miserable €2.50 to a stonking €12.50, and the company saw large institutional investors, including Blackstone Group, take positions for one of their customarily high-profile activist efforts–and watched as the market sent shares jeet-jacking up over 30% in less than a year;
Post-Reverse Split Stock Performance
When a reverse stock split hits, the new share price usually falls. Two-thirds of companies also see their stock price drop over the six months after a reverse split, PwC has found. In 2019, Chesapeake Energy saw its stock price plunge by more than 40% just two months after a reverse split. The company’s financial health is the main issue that underpins this trend, as market confidence in it would fatten its P/E multiple.
Nevertheless, there are cases where companies employ reverse stock splits to reassure the market. A 1:2 reverse split is nothing new, though; ask Apple; the company did precisely that in 2000 and watched its stock price soar by over 60% during the next year. The primary factor responsible for this turnaround was the company’s decided strategy of expanding and innovating in addition to rebuilding its investors’ confidence.
When It Can Be a Positive Signal
Considering how reverse stock splits are nearly universally bad, multi-day moves higher following the completion of a large in-reverse stock split can (and should) be seen as a good thing. However, if a company does announce other restructuring measures or positive news when it implements a reverse stock split — as is often the case with most companies that implement these splits — then market sentiment can move in its favor. A few months after the reverse stock split, Zoom announced solid fourth-quarter earnings and plans for growth over the next year that helped boost its share price by more than a third in just two months following the chop.
