Learning How to Profit from a Reverse Stock Split

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Reverse stock splits aim to reduce the number of shares outstanding for a public company to drive up the price of its stock. While the market cap and total share value stay the same, reverse stock splits make each share of stock worth more for investors.

However, reverse stock splits are often a sign of financial ruin for the company that may indicate their stock price is too low and they are at risk of being delisted from a major stock exchange.

Continue reading to learn how to profit from a reverse stock split and whether or not they are always a bad sign for investors.

What is a reverse stock split?

In simple terms, a reverse stock split is when a company consolidates shares of stock based on a multiplier, such as splitting the stock by 5, 10, or even 100. Reverse stock splits increase the share price of the stock but do not change the number of shares outstanding or the total value of the stock. 

This means that reverse stock splits don’t really accomplish anything other than the vanity metrics of an inflated stock price. Reverse stock splits aren’t as common today as regular stock splits which often means that the value of the stock is going up and the company needs to create new shares to account for the increase in share price.

Cons of reverse stock splits

While reverse stock splits aren’t necessarily good or bad by themselves, there are certainly some downsides of reverse stock splits that should be taken into consideration if one of the companies you’re invested in announces they’re undergoing a split. Below are the downsides of reverse stock splits:

• Reverse stock splits are often a sign of financial trouble. Most financial advisors will tell you that reverse stock splits may be a sign that the company is struggling and that its stock price is at rock bottom. 

• Companies may be at risk of being delisted from a major stock exchange. Perhaps the second most important reason that companies conduct a reverse stock split is if they are at risk of being taken off stock exchanges like the Nasdaq or NYSE. Delisting often takes place if a stock trades for under $1 for a certain amount of time.

• The stock price may cause investors to sell their shares. Since reverse stock splits consolidate stocks, the price of each share tends to increase but the number of total shares stays the same.

• The reduced number of shares may impact liquidity. Liquidity is an important part of running a successful business. One impact of a reverse stock split is that it may affect liquidity and lead to financial trouble down the line when raising cash.

Reverse stock splits vs. traditional stock splits

As we mentioned above, the difference between traditional stock splits and reverse stock splits is that a traditional stock split lowers the share price to make way for new shares to be created. Reverse stock splits often increase the stock price if the company is required to trade its stock at a certain price to maintain its standing in stock exchanges.

Reasons for reverse stock splits

Other than inflating the stock price, reverse stock splits don’t have many positive attributes. While a reverse stock split may not affect average investors, those diversified with other investments like mutual funds and index funds shouldn’t need to worry about reverse stock splits.

How to profit from a reverse stock split

Those looking to profit from a reverse stock split have a few options. Investors can short the company stock and buy the shares back if the price decreases. The only other way to profit from a reverse stock split is if you purchase shares before the reverse stock split and then sell for a short-term profit after the split.

Example of reverse stock splits

One recent example of a reverse stock split is General Electric, who in 2021 declared a reverse stock split since their stock price started to plummet. Unfortunately, the 1:8 reverse stock split only made things worse for GE, as the price is significantly down as of October 2022.

Final thoughts

Reverse stock splits are generally not a good sign for a company. While theoretically you can profit from a reverse stock split, it’s unlikely you’ll be able to time the market to get the profit you’re looking for. 

Those looking for stable consistent income should look into robo-advisors such as Betterment and Wealthfront as well as mutual funds and index funds.

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