High stock prices aren't the be-all-end-all, but sometimes public companies want to increase the cost of their share price. A reverse stock split makes a stock look more expensive (even though the equity is the same). Plus, the move can even keep the security trading on a major exchange.
Here's what reverse stock splits mean and whether or not it's a red flag for an investment.
Reverse stock splits, defined
A reverse stock split occurs when a public company decreases its total number of outstanding (sold) shares and decreases the price per stock at the same rate.
Each investor's position keeps the same overall value, but the number of shares in the position decreases while the stock's price increases.
This corporate action generally requires shareholder approval.
Reverse stock split ratios: What they mean
Reverse stock split ratios help investors understand the proportion the stock is changing at. For example, a 1-to-4 (or 1:4) reverse stock split means that a person with 4 shares now has 1, and each of those shares are now worth 4 times the previous value.
In a 1-to-3 reverse stock split, a person with 3 shares now has 1 share. Subsequently, each of those shares is now worth 3 times the previous value.
Why reverse stock splits happen
Companies perform reverse stock splits to increase the price of low-value stocks (including penny stocks). There are a couple of reasons for this:
The company wants to increase the perception of value for a low-priced stock to attract investors interested in premium offerings.
The company wants to stay on a major exchange. Whereas the UAE has the Dubai Financial Market, the US has the NYSE. The NYSE has a minimum stock price of $1 and gives warnings to companies who don't meet the threshold before delisting them.
If a company is desperate, it may perform a reverse stock split to generate buzz from analysts.
Are reverse stock splits bad news?
Reverse stock splits aren't like regular stock splits.
A normal stock split decreases the price of a high-valued stock and increases the number of outstanding shares. This can often be a good sign for prominent companies.
On the other hand, reverse stock splits are often a red flag. If a company gets delisted, you have to sell your investments in the OTC (over-the-counter) market, which is usually more volatile than the regular stock market. A company can perform a reverse stock split more than once, which would be an even bigger red flag.
As with any investment, considering the circ*mstances around the stock and overall market play a factor in your decision to buy or sell.
Examples of reverse stock splits aren't as common as cases of normal stock splits. This is because companies performing reverse stock splits tend to be smaller and less well-known. One example is Nxt-ID Inc. (NASDAQ:NXTD), which just performed a reverse stock split at a 1-to-10 ratio for Series C preferred stock.
