There’s a stock practice that most analysts and investors like to avoid called a reverse stock split (also known as a stock consolidation or share rollback). Most avoid reverse stock splits, as it doesn’t affect the fundamentals of the company so much as it improves investor perception or helps meet exchange requirements. But can they work for investors? Here’s my take, writes Nancy Zambell, editor-in-chief of Cabot Money Club.

Reverse stock splits reduce a company’s outstanding shares. It’s the opposite of a regular, or forward, stock split in which a company increases its shares. But just like a forward stock split, a reverse split doesn’t add to—or reduce—a company’s market cap or value.

For example, a company with five million outstanding shares trading at $1/share has a market cap of $5 million. If it decides to affect a 1-2 reverse stock split, that reduces the number of shares to 2.5 million. Its market cap remains the same—$5 million—so with 2.5 million shares outstanding, the share price is now $2 ($5 million divided by 2.5 million shares). Nothing changed except a reduction in the number of outstanding shares, which doubled the stock price.

But since the motivation behind most reverse splits is generally looked at unfavorably by the investment community, these splits often immediately create downward pressure on a stock, whereas a forward split, more often than not, pushes a stock’s price higher in the near term.

So, if the market views reverse stock splits with a jaundiced eye, you may ask, why would a company decide to do such a split?

1. The desire to increase the share price, especially if the shares are penny stocks. Low prices tend to elicit negative emotions in investors. They also inhibit the attention of the big money on Wall Street, not to mention analysts at major research firms.

2. Companies looking to create spinoffs at attractive prices may use reverse splits. 

3. Major stock exchanges have minimum dollar amounts for the price of the stocks they list. So, to stay listed, a low-priced stock may reverse split in order to push its price to those minimums.

4. And one more reason from Thomas Rice of The Bowser Report: A reverse split may just be an attempt to extend the life of a slipping stock.

While the last two reasons are mostly negative, the first two can be greeted as positive strategies by investors who take their reverse stock splits in stride, especially if they are confident that the company is serious about a turnaround or strategy to improve its fortunes. There are many examples of reverse splits in which a company’s shares not only survived but prospered.

Bottom line, a reverse split isn’t necessarily bad. As with any announcements that affect a company’s share price, reverse splits need to be analyzed thoroughly to determine if they are simply a desperation measure or a well-thought-out maneuver to create long-term value for a company.

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