Most investors like to see their stock split, as the idea of getting more shares intuitively seems like a better situation to drive future growth. Reverse stock splits, however, leave shareholders with fewer shares, and they often result from situations in which a stock has lost a substantial amount of its value. The reverse split itself doesn't result in any change in the value of an investor's position in a stock, because the smaller number of post-split shares is offset by the proportionally higher per-share price. However, stocks that go through reverse splits often see renewed selling pressure following the split, and the number of companies that emerge from reverse splits to produce strong long-term returns is small.
What a reverse split does
Reverse stock splits work the same way as regular stock splits but in reverse. A reverse split takes multiple shares from investors and replaces them with a smaller number of shares in return. The new share price is proportionally higher, leaving the total market value of the company unchanged.
For instance, say a stock trades at $1 per share and the company does a 1-for-10 reverse split. If you own 1,000 shares -- worth $1,000 at current prices -- you'll get 1 new share for every 10 old shares you own, or 100 new shares. The stock price will rise tenfold to $10 per share. That will leave your smaller position still worth the same amount, as 100 shares multiplied by $10 per share equals $1,000.
Why reverse stock splits rarely work
In general, a company does a reverse split because it needs to get its share price up. The most common reason for doing so is to meet a requirement from a stock exchange to avoid having its shares delisted. For example, the New York Stock Exchange has rules that allow it to delist a stock that trades below $1 per share for an extended period of time.
In many situations, however, a stock continues to fall following the reverse split. In part, that stems from short-sellers being able to borrow new shares and keep betting against the stock, which becomes more difficult when a share price falls below certain levels.
When reverse splits pay off
Sometimes, however, a reverse split buys a company the time it needs to get back on track. For instance, a reverse split worked for internet-travel giant Priceline, which did a 1-for-6 reverse split following the internet tech bust. Since then, shares have risen more than 60-fold, and the company has never seen the need to split its share back to offset the impact of the reverse split.
Despite the occasional success story, reverse splits aren't usually a good sign for a stock. Still, they don't have to be a death knell, either. Because reverse stock splits have no fundamental impact on a company, it's more important to look at the financial health of a stock to assess whether a reverse split is likely to work in the long run.
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