A reverse stock split occurs to decrease the total number of outstanding shares of a company. Since this strategy does not change the company’s market capitalization, its effect is to increase the stock price. This is because once the transaction is completed, the market capitalization of the company is divided by a fewer number of shares.
A reverse stock split works the same as a stock split, but in reverse. For example, in a 2-for-1 share split, the company takes both shares and combines them into one.
By way of illustration, a company with 200,000 shares in circulation at a price of $15 per unit decides to carry out a 2-for-1 share consolidation. The company thus divides the number of shares in circulation by two, going from 200,000 to 100,000 shares outstanding. Its market valuation remains the same, so the price of a share will then double, from $15 to $30 after consolidation.
Companies use a reverse stock split when they want to increase the price of their stock. The most common reason for this is to meet a stock exchange requirement, which generally require listed companies to maintain their stock price above a specific dollar amount.