Updated on Wednesday, December 30, 2020
Many are familiar with stock splits, where investors receive new shares of a companyâ€™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 â€” but instead it effectively merges existing shares to reduce the number of shares that are publicly traded.
Hereâ€™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.
Whatâ€™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 companyâ€™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. Itâ€™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 itâ€™s cut into four parts and you get a slice, thatâ€™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 â€” the price â€” and how many you get.
Reasons for a reverse stock split
While investors generally view forward stock splits favorably, the same canâ€™t be said for reverse splits. Thatâ€™s because reverse splits usually follow some kind of negative event in the companyâ€™s life that has seen the stock decline for months or years. The reverse split is often associated with bad news, although itâ€™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 companyâ€™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 thatâ€™s not what most legitimate companies want to have. A reverse split can boost the stock to a â€śrespectableâ€ť priceâ€” 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 companyâ€™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 werenâ€™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.
Itâ€™s important to note that the reverse split in and of itself doesnâ€™t fix the problems that likely led to a stockâ€™s decline â€” itâ€™s simply a stock maneuver.
Pros and cons of reverse stock splits for investors
Pros of reverse stock splits
- Keeps the stock listed on the exchange: 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 â€śmore roomâ€ť to fall before it becomes problematic again.
- Can help relieve selling pressure: A reverse split keeps the stock above a certain threshold â€” often $5 or $10 per share â€” below which some funds may not be able to hold the stock or buy more. Thus, a reverse split would allow these investors to remain as stockholders, avoiding further selling pressure.
- Can be a sign a company 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 hasnâ€™t plummeted and management clearly spells out why itâ€™s doing the reverse split. A management team that tries to consider the needs of investors is likely a good investment.
Cons of reverse stock splits
- Can be an indicator of poor performance: When a company undertakes a reverse split, its poor operational performance is already reflected in its declining stock. The reverse split doesnâ€™t create a declining stock; itâ€™s an effect, not a cause, of poor performance. Still, 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.
- Could signal sinking stock: From a cynical perspective, 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 doesnâ€™t run into immediate trouble with the exchange or its shareholders.
How do stocks perform after a reverse split?
Stocks tend to lag the market after a reverse split â€” thatâ€™s not surprising if a reverse split signals that management thinks the stock will continue to decline.
However, itâ€™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 investorsâ€™ hands, not a real operational repair of the business.
For investors, stock splits generally should be seen as a nonevent since they donâ€™t increase the value of an investorâ€™s holdings. However, some research indicates that forward stock splits signal managementâ€™s confidence in a stockâ€™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.