What Is a Reverse Stock Split, and What Does It Mean for Your Portfolio?

Many 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. Like a stock split (also called a forward stock split), a reverse stock split distributes new shares of stock to investors — but instead it effectively merges existing shares to reduce the number of shares that are publicly traded.

Here’s what a reverse stock split means for your stock, including why it can sometimes be a good thing.

What is a reverse stock split and how does it work?

In a reverse stock split, a 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.

What’s the difference between a forward vs. a reverse 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.

Reasons for a reverse stock 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 it’s not necessarily bad in and of itself.

Here are several reasons why a company might undertake a reverse stock split, including a couple of positive reasons:

• Avoid getting 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. A reverse split can boost the stock to a “respectable” price— this may in turn 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. By doing a reverse split, the stock gets 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. 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.

Pros and cons of reverse splits for investors

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.

For investors, stock splits generally should be seen as a nonevent 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. That being said, reverse splits rarely come out of the blue; they typically follow months, if not years, of declining stock prices.

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