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A reverse stock split occurs when a publicly traded company reduces the number of its outstanding shares. A reverse stock split decreases the number of outstanding shares and proportionately increases the price per share of those outstanding shares. This process differs from a forward stock split, where the number of shares increases and the share price declines post-split.
Reverse stock split: What it means
With a traditional forward stock split, a company increases the number of shares outstanding and lowers the price per share by the same ratio. For example, with a 2:1 stock split, the number of shares increases by two times while the share price is divided by two.
With a reverse stock split, that calculation is effectively flipped. In a reverse stock split, a company reduces the number of shares outstanding, boosting the share price. For example, with a 1:3 stock split, the number of shares is divided by three while the share price is multiplied three times.
In either case, the company’s total market capitalization – the total value of all its shares – remains the same.
One recent example of reverse stock split occurred at General Electric, which completed a 1:8 stock split in July 2021. This corporate action increased the share price by eight times on the effective date of the reverse split and reduced the number of shares outstanding by dividing the pre-split total by eight.
Why do companies do reverse stock splits?
A company may conduct a reverse stock split for several reasons.
Prevent being delisted
If a company’s share price gets too low, a stock exchange might delist the stock from the exchange. Being listed on an exchange is important to ensuring public trust in a company, maintaining investor interest and raising capital. A reverse split can be a quick way to push the share price above the exchange’s required level for continued listing.
Boost the share price to improve investors’ perceptions of company
If a company’s share price falls into the single digits per share or lower, investors may look at the shares as a penny stock and become skeptical of its business prospects. A low share price may also put the stock off-limits for some investors, especially institutional investors, which may be required by their charter to avoid shares with a low price per share.
Keep the stock in a normal trading range
A reverse split may also move a stock back to a normal trading range, which can range from $20 a share to $120 a share or thereabouts. If a stock’s share price falls too far, it may drop off the radar of influential stock analysts and institutional investors.
Are reverse stock splits good or bad?
All things equal, a reverse stock split is neither good nor bad and has no impact on the value of the total company. However, it often carries a negative connotation as many of the companies doing them are countering a sharp drop in their share price. Some investors may view a reverse split as a way to boost the stock price without an actual improvement in the fundamental business.
“It is usually a very negative sign when a company reverse splits their stock,” says Charles Kaplan, president of the investment consulting firm Equity Analytics. He indicated that the market reaction is often dependent upon other steps the company may take to reverse the situation that has led to its lower share price.
What happens to your shares following a reverse stock split?
The total value of the shares — the company’s market capitalization — will be the same after the reverse split as it was prior to the split. The minor exception to this would be if the company decided to pay out as cash any fractional shares that would result from the reverse split.
If your shares are held by an online stock broker or other type of custodian, the transaction will be seamless and will be handled electronically.
There would normally not be any tax implications from a reverse stock split. One exception is a reverse split where cash payments were issued to shareholders in lieu of fractional shares. These distributions may be subject to capital gains taxes depending upon the shareholder’s cost basis and holding period. This would not be an issue if the shares are held in a tax-advantaged retirement account such as an IRA.
Whether a reverse stock split ultimately works out to be a positive or negative for shareholders will depend on the situation surrounding the specific company. Investors should look at any reverse stock split based on the unique issues and fundamentals of the individual company and its stock.
Bottom Line
Reverse stock splits can serve as a solution for companies facing delisting or struggling with a low share price. While they may carry a negative connotation, their impact on shareholders ultimately depends on the specific circ*mstances of the company. As investors, it is important to carefully evaluate the reasons behind a reverse stock split and consider the long-term potential of the company.
