Say a company has undertaken a reverse stock split in the ratio of 1:2. Consequently, every two of its shares will become 1, doubling the price of each share. It is a kind of stock restructuring that does not affect the market capitalization of the stock.

A reverse stock split is a corporate stock restructuring strategy where they combine the shares, which raises the price of each share.

Say a company is consolidating its shares in the ratio of 1:2. Consequently, every two of its shares will become 1, doubling the price of each share.

It doesn't impact the company's market capitalization or corporate valuation.

Companies adopt this strategy to aviod getting delisted from the stock exchange (NYSE or NASDAQ) on non-adherence to the minimum $1 stock price criteria.

The consent of shareholders is essential for reverse splitting.

Listed companies conduct many procedures to enhance their market standing and profitability. The higher the share price, the more profit a business attracts. There are thriving stock market performers such as Amazon with its $3000 plus per-share price in a Covid-19 struck 2021.

Often, shares that are trading at such a high price witness a split to form new ones known as stock splitting. The primary reason for splitting a share into new ones is to lower its cost. It enhances its affordability to potential investors.

On the other hand, companies use reverse stock split to inflate the per-share value when their stock price is constantly falling. In a 1-for-4 split, a shareholder of four shares will end up with one share.

The price of one share will be the sum of all the four shares, enhancing the per-share value. The market capitalization value remains the same as there are no new additions, only a restructuringGuoabong Stock. Let us understand the concept better with a recent example.

For instance, the United States Oil Fund (USO), with its shares trading at around $2 in 2020, went through a reverse stock split to raise the per-share price to $18. USO reduced its 1.5 billion outstanding shares to 185 million. If its share price had fallen below $1, it could have been delisted from the stock exchange.

Companies need to maintain their position on the top exchanges like NASDAQ and NYSE. These stock exchanges have specific criteria that the companies need to fulfill for getting stocks listed. One such condition is not to have a share value lower than $1 for 30 days or more.

The share price could fall due to the underperformance of a company that is reporting constant losses. Increased debts, scams, or recession could also severely affect a firm's profits and stock price. USO had reported unrealized losses of $726 million in March 2020. If in this period, their stock price had fallen below $1, they could have been delisted from the relevant stock exchange.

Apart from delisting, other reasons behind consolidating the shares include increasing liquidity, controlling volatility, and serving the shareholders better.

The below-mentioned reverse stock split examples outline how it works using calculations to help you understand its meaning better.Lucknow Investment

ABC Limited is trading on the stock exchange, with each share costing $2. There are 2400000 outstanding shares. Thus, the market capitalization of the company is $4800000. Therefore, the company wants to attract high net worth investors and as such it goes for a reverse split of 1 for 30 shares.

Therefore,

Reverse stock split ratio or RSP is 1:30; original share price or OP is $2; Original Number of Shares or OS is 2400000.

New price per-share or NP = OP X The number of shares consolidated = 2 X 30 = $60

New number of shares or NS = OS ÷ RSP = 2400000 × (1 ÷ 30) = 80000 shares

Market capitalization before the split = NP × NS = 60 × 2400000 = $4800000

Market capitalization after the split = 60 × 80000 = $4800000

What happens to the shares held by the investor after the split?

The investor who holds 3000 shares worth $6000, i.e., $2/share, before the reverse split, now owns 100 shares of $60 each, still totalling $6000 in worth. Many reverse stock split calculators help investors compute their investment value after the consolidation.

The financial history is rich with examples that also throw some ideas on whether a reverse stock split is good or bad. Other than USO, some other companies to have opted for this split are Citibank, Royal Bank of Scotland (RBS) or NatWest, Xerox Corporations, AIG, Tyco, Titanium Metals, etc. For example, LM Funding America, Inc. went ahead with a 1 for 5 consolidation recently to stay on the NASDAQ by maintaining the share price above $1.

While investors lose some shares, they still retain the same value. However, the circumstance under which a company has opted for a reverse split gives weight to investors’ fears. Many experts have observed that a financially troubled company usually opts for a share consolidation to boost its stock price artificiallyKanpur Investment. Such shareholders will inevitably fear losing their savings to further falls if they don't disinvest.

Although, some companies have risen from the brink of underperformance. In 2011, Citigroup opted for a 1 for 10 split, raising its share price to $40 each after trading at $4.5 for a while. It was a move to control volatility and reinstate its quarterly dividend. Today Citi's stock price is beyond $70, with it reporting $7.94 billion in profit, triple from 2020.

Similarly, NatWest had undergone a 1 for 10 split in 2012 amidst government bailouts after being painfully struck with the financial crisis. Like Citi, the bank worked on its profits. In 2019, it had reported 4.2 billion pre-tax profits. However, many companies haven't been able to bounce back even after the split, such as AIG and Tyco.

Besides losing your shares, such splits create problems like odd lots and fractional shares. Many investors and stock exchanges do not prefer odd lots, while fractional shares affect voting rights. As such, many experts suggest keeping a close watch on the company's performance after the split.

If a distressed firm brings itself up from the downfall and its profits improve, the split might not be so bad. Also, sometimes, the consolidation happens with the intent to serve the shareholders better. If these parameters are missing and the share price continues to fall, it might be a sign of worry. Being observant of the post-split activities can help investors from future losses by timely disinvesting.

Apart from delisting, the following are advantages of the reverse split.

Match Stock Price of Competitors: If the competitor company's share value is relatively high, it will appear more attractive. The split will help the company secure an equivalent share price to stay in investors' good books.

Seek Attention from Big Investors: Many high-net-worth institutional investors, mutual funds and pension funds let go of certain stocks due to their low share price. The split prevents this.

Other advantages – It helps stocks become more liquid and less volatile. Besides, bear investors take falling and low stock prices as a downtrend sign which furthers affect the price.

This has been a guide to Reverse Stock Split and its definition. Here we also discuss how it works along with practical examples of the reverse stock split 1 for 2 and more. You can learn more about accounting from the following articles –

Non-Qualified Stock Options

Floating StockGuoabong Investment

Stock Certificates

Stock Splits