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.
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.
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.
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:
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.
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.
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