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Updated on Monday, February 4, 2019
Investors are familiar with stock splits — where investors receive new shares of a company’s stock in proportion to their existing holdings — but less well-known are reverse stocks splits. Here’s what a reverse stock split is and what it means for your stock, including why a reverse stock split sometimes can be a good thing.
How a reverse stock split works
Like a stock split (also called a forward stock split), a reverse stock split distributes new shares of stock to investors. However, there are some important differences between the two, and it’s helpful to understand what a forward stock split is before tackling what a reverse split is. (Here’s a quick refresher on what a stock is and why investors own them.)
Understanding a forward stock split
In a forward stock split, the company distributes new shares at some specified ratio. For example, in a 3:1 stock split, investors receive three new shares for every old share. Simultaneously, the stock price is divided by the split factor so that the company’s market capitalization remains the same. In a 3:1 split, the former stock price would be divided by three.
In other words, you get three times as many shares, but each share is worth one-third as much as before. It’s important to note that the total value of your stock does not rise with a stock split.
So imagine you owned 100 shares of a stock trading at $120 per share. The company announces a 3:1 forward split. After the split, you would own 300 shares trading at $40 per share. Both before the split and after, the total value of your shares is $12,000.
A stock split is like slicing up a pizza. If it’s cut into four parts and you get a slice, that’s the same as a pizza cut into eight parts and getting two slices. Either way, you own one-fourth of the pie. Like the stock split, the only change is in the size of each slice — the price — and how many you get.
What happens in a reverse stock split
In a reverse stock split, the process is flipped. Instead of extra shares, the company issues one new share in exchange for multiple shares of the old stock. For example, in a 1:4 reverse split, the company would provide one new share for every four old shares.
So if you owned 100 shares of a $10 stock and the company announced a 1:4 reverse split, you would own 25 shares trading at $40 per share. The total value of your position remains the same, with the number of shares and the stock price being adjusted by the split factor.
Why a company might do a reverse split
While investors generally view forward stock splits favorably, the same can’t be said for reverse splits. That’s because reverse splits usually follow some kind of negative event in the company’s life that has seen the stock decline for months or years. The reverse split is often associated with bad news, although in and of itself it’s not bad.
Here are several reasons why a company might undertake a reverse stock split, including a couple of positive reasons.
Avoid being delisted from the exchange
If a company’s stock falls below $1 per share for an extended period of time, the exchange may delist it. To cure this deficiency, the company can conduct a reverse split, moving the stock price above the threshold.
Make the company appear more legitimate
Stocks under $5 per share are considered penny stocks. Penny stocks have a bad reputation, and that’s not what most legitimate companies want to have. So a reverse split can boost the stock to a “respectable” price. This may lead to increased attention from analysts and investors, who may see the company as more legitimate at the higher price.
Allow the stock more room to fall
Executives may be anticipating the stock to fall further due to the company’s poor operating performance, and a reverse split boosts the stock price, giving it more room to fall without going into penny stock territory.
Adjust the price during a spinoff
Sometimes a company spins off another wholly owned company, but this new company may have a stock price that would be too low if it weren’t adjusted higher through a reverse split. So the reverse split gets the stock back into a normal trading range and can make the company look investable.
Lower the costs for investors
For large institutional investors, buying more shares increases transaction costs substantially. So with a reverse split, a company can make it cheaper for investors to own a sizable percentage of the company.
It’s important to note that the reverse split in and of itself doesn’t fix the problems that likely led to a stock’s decline. It’s simply a stock maneuver.
Reverse stock splits: the good and bad for investors
Reverse stock splits can have several, usually negative, implications for investors. When a company undertakes a reverse split, its poor operational performance is already reflected in its declining stock. The reverse split doesn’t create a declining stock; it’s an effect, not a cause, of poor performance. A reverse split is often a wake-up call to investors, who should ask themselves why they still own the stock and whether they may want to consider selling it.
As a stock declines, the management team may conduct a reverse split to keep the stock listed and trading on the exchange. If the exchange is threatening to delist the stock because of a low price, a reverse split cures this problem. By raising the stock price, a reverse split allows the stock “more room” to fall before it becomes problematic again.
Or similarly, a reverse split keeps the stock above a certain threshold — often $5 or $10 per share — below which some funds may not be able to hold the stock or buy more. So a reverse split allows these investors to remain as stockholders, avoiding further selling pressure.
From a cynical perspective, however, a reverse split may indicate that management thinks the stock will continue to fall rather than go back up. Management may boost the price so that the company doesn’t run into immediate trouble with the exchange or shareholders.
All that said, sometimes a reverse split can be a sign of a company that is considering the needs of its shareholders. For example, the company may want to reduce transaction costs for investors, and reducing the share count offers a way for investors to own the same percentage of the company but with fewer shares. In positive situations such as this, the stock usually hasn’t plummeted and management clearly spells out why it’s doing the reverse split. A management team that tries to consider the needs of investors is likely a good investment.
How do stocks perform after a reverse split?
Stocks tend to lag the market after a reverse split. That’s not surprising if a reverse split signals that management thinks the stock will continue to decline. However, it’s worth repeating: A reverse split is an effect of poor performance, not a cause. The stock often has already been on a long downtrend, and the reverse split is just a gimmick to keep the stock on the exchange or in investors’ hands, not a real operational repair of the business.
Stock splits generally should be seen as a nonevent for investors since they don’t increase the value of an investor’s holdings. However, some research indicates that forward stock splits signal management’s confidence in a stock’s rise, while reverse stock splits signal the continued decline of the business. But reverse splits rarely come out of the blue; they follow months, if not years, of declining stock prices. So you’ll need to consider what a split means for your stock — it’s all part of learning how to invest in the market.