When I was around 15 years old, I used to trick my younger sister into believing she was making a better deal than she actually was.
I would ask her for a €50 note, and in exchange, I would give her nine notes of €5, making it a €45 total. She would be pretty excited about that since the number of notes was much higher than before, giving it the illusion that she was now much wealthier.
Obviously, you can see the problem, and so did I. In the end, I would give it back and explain to her what had really happened.
Without being aware, she witnessed a Stock Split (more quantity, less nominal value per note – supposing I would give her ten notes of €5), and, on the other side, I was facing a Reverse Stock Split (less quantity, higher nominal value per note).
I hope this example gives you a clue about what a Reverse Stock Split might be. Want to know more details about a reverse stock split and how to profit from it? Let’s dive into the details!
What is a Reverse Stock Split?
A Reverse Stock Split is a corporate event in which a company’s board of directors decides to reduce the number of outstanding shares to get a higher share price. It has zero effect on the company’s value, so the market capitalization remains the same.
For example, suppose a stock trades at €10, and you, as a shareholder, own 100 shares of the company’s stock, making it a total investment of €1000. The corporation decides to do a 1-for-5 reverse stock split, which means that each stock will be worth €50, and the number of shares you will possess shrinks from 100 to 20. Note that the outcome is still €1000 (€10*100 is equal to €50*20). As you can see, the reverse stock split does not change the company’s value by itself.
Following this case, it is pretty clear that you cannot profit from a reverse stock split. Still, the signal it gives to the market participants may change the stock dynamics by increasing volatility and affecting the stock’s short and long-term performance (more on it later).
Reasons for a Reverse Stock Split
At first sight, it is puzzling why many firms engage in these financial maneuvers since stock splits have no impact on their financials. However, there are some valid motives for a reverse stock split:
- The company may leave relevant stock indices. Stock exchanges have a list of requirements that the listed companies must fulfill. For instance, in the New York Stock Exchange (NYSE), a company’s stock that trades below $1 for more than 30 consecutive days will receive a notification letter alerting of the possibility of delisting if no action is taken to restate its original status;
- Attract more “smart money”  investments. Stringent rules guide the majority of Institutional investors when it comes to investment. Some define the minimum exposure to specific asset classes and prohibit them from investing in High Yield Bonds, while others include restrictions in the nominal value of the stocks (no investment in stocks trading under $5, for example);
- It may increase the company’s reputation. There is a negative stigma regarding stock trading with a low nominal value, usually associated with penny stocks (high-risk investments). Besides, you can see that by the composition of the Dow Jones Industrial Average (DJIA) and the Nikkei 225, which are both Price Indices (the value of each share determines the importance of each stock within each index. It is not shaped by market capitalizations like the S&P 500 index);
- It attracts more scrutiny from analysts and investors worldwide. A higher stock price increases the chances of appearing on the radar of several investors that otherwise would not even be aware that the company exists.
Another reason that does not fit under the examples of the company’s stock is related to the nature of the instruments’ nature. A clear example is the United States Natural Gas Fund, LP (UNG), an ETF designed to follow natural gas prices. We do not want to overwhelm you with the technical details. Still, one reason for several reverse stock splits in its history, besides the steady decline of natural gas prices, is because of the fund’s structure (future contracts that need to be rolled and, in contango, the rolling yield is negative – if you are curious about it, read this article).
 Cash from investors considered highly experient and well-informed.
Implications of a Reverse Stock Split
Despite not impacting the company’s value by itself, it can completely change the company analysis. A famous metric used by financial analysts is the Earnings per Share (EPS) which will increase after the reverse stock split. This means that prior analysis will need to be readjusted in order to keep the following analysis consistent and reliable.
Besides, it will induce a cascade effect in financial ratios used for valuation such as the Price to Earnings (P/E), the Price/Earnings to Growth (PEG) Ratio, Earnings Yield and Dividends per Share (DPS). All these ratios will change, and proper adjustments must be made. Otherwise, it will be impossible to compare them with previous years and use them for relative valuation.
What does a Reverse Stock Split tell investors?
It may send mixed signals for the market participants. On the one hand, it can transmit that the company is making internal structure changes and wants to say to the market something like: “we will make an effort to keep our stock price higher and, for that, we are willing to adapt our current business model to the new market environment”.
On the other hand, a reverse stock split is usually done by companies with difficulty attaining steady profitability and creating value for their shareholders. Some are even on the verge of bankruptcy, and they use a reverse split as a last-ditch effort to revive their failing fortunes.
Performance of Stocks after Reverse Stock Splits
Several academic studies show a negative stock performance after the announcement and realization of a reverse stock split.
In 2018, Seoyoung Kim, April Klein and James Rosenfeld, in the paper “Return Performance Surrounding Reverse Stock Splits: Can Investors Profit?” concluded that in the long-term performance of over 1,600 firms, there was a “statistically significant negative abnormal returns over the three-year period following the month of the reverse split”.
Moreover, they stated that “the sample firms experience poor operating performances over the four years that include and follow the year of the reverse split, which suggests informational inefficiencies”.