Key Takeaways
- Market watchers argue that reverse stock splits do nothing to improve a company’s fundamentals.
- They simply raise the stock price by reducing the number of shares available.
- Reverse splits are often seen as distress signals—last-ditch efforts to avoid delisting or to mask deeper woes.
When a company announces a reverse stock split, experienced investors typically view it as a warning sign. The move, which boosts the share price by shrinking the number of shares outstanding, is rarely a sign of business strength. As Robert R. Johnson, a professor of finance at Creighton University, told Investopedia, “Healthy companies don’t engage in a reverse split of stock.”
Reverse stock splits were relatively rare a decade ago—there were only a few dozen in 2015. But the pace has climbed steadily, until new highs were set each of the last two years. As of Sept. 10, there have been 345 reverse splits, on pace to beat last year’s record.
What Is a Reverse Stock Split?
A reverse stock split is when a company consolidates its shares into fewer, higher-priced shares. For example, in a 1-for-10 reverse split, one new share is issued for every 10 old ones, making each share 10 times as valuable while reducing the number available. Importantly, this maneuver doesn’t change the overall value of the company or improve its business prospects; it just adjusts the supply of shares.
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Why the Market Doesn’t Like Reverse Stock Splits
The market often interprets reverse splits as a company’s last-ditch effort to cover up more serious problems, so investors usually react with skepticism or outright selling. Reverse stock splits are a red flag because they are common “for companies coming out of bankruptcy… or when the share price declines to a low value,” Johnson said. Experienced investors know that high-quality firms don’t need to artificially boost share prices.
Reverse stock splits often suggest that a company is struggling, potentially facing delisting from exchanges like the Nasdaq or New York Stock Exchange if they’re trading at “penny stock” levels. Johnson calls this the “cats and dogs” range because the stock’s price is below $5 per share.
Reasons Companies Engineer Reverse Stock Splits
Companies opt for reverse stock splits for a range of strategic reasons, including the following:
Avoiding Delisting
Public exchanges require companies to maintain a minimum share price, typically $1 for the Nasdaq. Falling below that threshold can result in being kicked off the exchange, a significant blow to credibility and market access. By boosting the share price, companies hope to avoid this fate.
Attracting Institutional Investors
Stocks trading under $5 are generally shunned by institutional investors, who view them as too risky or speculative. By performing a reverse split, companies aim to increase their share price, making their stocks more attractive to mutual funds and pensions, although the underlying risks typically remain.
Restructuring After a Bankruptcy
Firms emerging from bankruptcy often sport ultralow share prices and bloated share counts. A reverse split is a way to make the stock look more presentable and possibly attract new investment. For example, a 1-for-50 split isn’t uncommon.
Maintaining Stock Market Perception
Some companies use reverse splits to boost their profile, believing that a higher share price might attract more interest from retail traders or lend an air of stability. This is more about optics than substance, and rarely fools the market for long. According to Johnson, though, these maneuvers do little to reset market sentiment, especially when deeper business problems remain.
The Bottom Line
Reverse stock splits are rarely the success stories that companies (or their press releases) want investors to believe. While they might provide temporary relief from exchange rules or attract certain types of investors, they do nothing to address core business issues. For investors, a reverse split should prompt a hard look at the company fundamentals.