These days, the standard (or "forward") stock split garners a lot of attention. In fact, some of the country's most prominent companies have enacted such splits in recent times, including Tesla, Apple, and Amazon.
By contrast, there have been relatively few reverse stock splits, even at a time when standard ones are occurring on a regular basis. Here's a brief look at why they are such elusive creatures.
Reverse financial engineering
Before looking at the "why" of reverse stock split elusiveness, let's first back up and take care of the "what" of this piece of financial engineering.
As its name implies, a reverse stock split is the opposite of a standard stock split. In the reverse variety, the number of shares outstanding shrinks, whereas with its more common sibling the share count increases. When a reverse stock split is enacted each share's price jumps suddenly and dramatically higher, rather than falling at once as with standard stock splits.
It's critical to note here that while it can be awfully gratifying to see a stock leap five, or 10, or 20 times almost out of the blue, the actual value of your holding doesn't change. With reverse stock splits, the increased price is mitigated by the reduced number of shares, so the dollar amount of equity you own stays the same.
For example, imagine a company's stock trading at $1 with 1,000 shares outstanding, giving it a market value of $1,000. After a 1-for-5 reverse split, there will be 200 shares outstanding at a price of $5. Although the price of each share is five times higher than before, each investor now has only one-fifth as many shares and the market cap remains unchanged at $1,000.
There are several compelling reasons for a publicly traded company to increase its stock price. A big one is stock exchange listing requirements: the major exchanges have minimum price requirements for companies. In the case of the Nasdaq, for example, the floor is $1 per share because it doesn't want to take on the look of a penny stock-trading marketplace.
If all goes well, a reverse split keeps the exchange happy while the company tries to figure out a way to improve its performance enough to organically increase the value of its stock.
Stock exchanges are not the only entities that insist on a minimum per-share price -- many investment funds (and other entities with equity portfolios) do, too. Demand for a stock, particularly one of a company that's not particularly well known, can be strongly affected by its presence in such portfolios. It's understandable that a company wouldn't want to drop off the radar screens of fund managers.
Most businesses that land on the more prominent exchanges, or in the portfolios of investment funds, have done so by being competent enough to get to a certain size. The ones that mismanage their operations badly enough (or are simply very unfortunate) are relatively uncommon, hence the rarity of the reverse stock split. After all, this is very often a desperation measure by a business in real trouble.
So are reverse stock splits good or bad?
In a word: neither.
The Motley Fool's research indicates that neither form of stock split, standard or reverse, is a reliable indicator of how a company's shares will perform over the long term.
A company that does a reverse split might take a price hit in the short term, likely because the move shines an uncomfortable light on its struggles. As with standard splits, though, medium- to long-term share price movements have more to do with the traditional factors affecting stocks. These include fundamental performance, the state of the macroeconomy, and investor expectations, among numerous other elements.
So while a reverse stock split is often indicative of a company in the throes of struggle, no investor should make a buy or sell decision based purely on such a move. Instead, you are far better served by thoughtfully weighing those longer-term factors.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Eric Volkman has positions in Apple. The Motley Fool has positions in and recommends Amazon, Apple, and Tesla. The Motley Fool recommends Nasdaq and recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.
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