If you read our article about stock splits, you should know this happens when a full stock gets divided into more shares. However, if you don’t feel quite comfortable with its basics yet, make sure to check it out ASAP and come back later. Here we are going to learn all about the reverse stock split, what it is, and how it works.
Reverse stock splits
A reverse stock split is the exact opposite of the stock split. What does that mean?
In a stock split, the number of shares increases and the price per each decreases. Now, in a reverse stock split, the number of shares a company has in the market is reduced, elevating the price of each stock.
A reverse stock split happens when the price of a company’s stocks has dropped drastically. For example, if the share price is worth $1 or below, the stock not only takes the risk of getting delisted from the market, but it will also have a riskier appearance to new investors. It is common for a reverse split to happen in this kind of scenario.
Reverse stock split in action
Let’s make it easier with an example:
Imagine the company Billy’s Big Burger got hit really hard by the pandemic. They were forced to close some restaurants and lay off some staff, therefore, the price of its stock took a nosedive. Now, with new safety guidelines implemented and the world economy recovering, they want to grab the attention of new investors by increasing the price of their stocks in the market, so they decide to have a reverse stock split.
Let’s say you invested a total of $25 to buy five of Billy’s Big Burger’s stocks right before the crisis. Keeping in mind what we just learned, we know that in the case of a 1-for-5 reverse stock split the number of their shares available in the market will reduce, but their price will jump from $5 to $25 per share.
What’s going to happen? Once the reverse stock split happens, you’ll no longer be the proud owner of five shares worth $5 each, but you’ll have only one Billy’s Big Burger stock worth $25, the total amount you invested at the beginning.
You might think that with the reverse stock split the company and its shares will decrease their value. WRONG!
The only thing that decreases is the number of available stocks; the price per share changes proportionally; therefore, the value will continue to be the same.
For instance, if you bought $25 worth of stocks, your investment will keep the same value after the reverse split. What will change is the perception new potential buyers may have of the new stock price.
Reasons to get a reverse stock split
A company may decide to reduce the number of its shares in the market for a number of reasons. Here are some of the most important:
- Stay on the market: Some stock exchanges may delist a stock that keeps a price below $1. In case of a removal, the company’s shares become penny stocks and are pushed to alternative marketplaces where it is harder to buy and sell.
- Attract investors: Some big institutional investors and investment funds keep regulations regarding minimum prices of the stocks in which the invest. By maintaining a higher price per share, a company keeps the eye of big investors that could help increase the popularity of the holdings by going big purchasing its shares.
- Keep regulators happy: By reducing the number of shares available in the market, a company may also aim to lower the number of shareholders to fulfill the set of regulations set to its jurisdiction.
Now that you know all this, you won’t get easily amazed by the increase of a stock price after a reverse stock split. From now on, it will be easier for you to decide whether investing in a specific stock is a good decision for your investment strategy.
Before diving into the market, make sure to check out additional articles from our blog to learn more about the strategies in the stock market and assure the success of your financial future. Good luck!