Why Would a Company Perform a Reverse Stock Split?

What Is a Reverse Stock Split?

A reverse stock split is a measure taken by a public company to reduce its number of outstanding shares in the market. Existing shares are consolidated into fewer shares. This results in a higher stock price for the stock shares but has no immediate effect on the total value of the stock to the investor or the market capitalization of the stock.

For example, if a stock is trading at 50 cents on the market, and the company declares a two-for-one reverse stock split, an investor who owned 100 shares worth 50 cents would own 50 shares worth $1 each.

How a Reverse Stock Split Works

When a reverse stock split is executed, a company cancels its current outstanding stock and distributes new shares to its shareholders in proportion to the number of shares they owned before the reverse split.

For example, in a one-for-ten (1:10) reverse split, shareholders receive one share of the company's new stock for every 10 shares that they owned. Each new share would be worth ten times that of the shares before the split. A shareholder who held 1,000 shares would end up with 100 shares after the reverse stock split was complete.

(The process is the reverse in a stock split. Each stockholder receives two or more shares for every share held at the time of the split.)

A reverse stock split has no immediate effect on the company's value, as its total market capitalization remains the same. It has no immediate effect on the value of the stock to the investor, either.

However, a reverse stock split is often unwelcome news to the investor as it is seen as a sign that the company is in financial trouble. Some loss in market value often follows a reverse stock split as investors unload their shares.

It does not reward investors at dividend time, either. If the company pays cash dividends, future dividends would be adjusted to reflect the new, lower number of shares outstanding. So, if a company paid its shareholders a $1-per-share dividend and it undergoes a 1:5 reverse split, the dividend becomes $5 per share or five times the old payout. The dividend payment is unchanged.

Reasons for a Reverse Stock Split

There are a number of reasons why a company may decide to execute a reverse stock split and reduce its number of outstanding shares in the market. Here are the main motives:

• Prevent delisting: If a stock price falls below $1, it is at risk of being delisted from stock exchanges that have minimum share price rules. The company's shares then enter "penny stock" territory and can only be bought and sold as over-the-counter stocks.
• Boost the company's image: A stock that trades in single digits is generally viewed as a risky investment. A reverse split gives the spurious appearance of a more valuable stock.
• Increase interest in the stock. Higher-priced stocks attract more attention from market analysts and more coverage by the business news media. A company that is ignored by analysts and the media is likely to fall into obscurity.
• Increase trading in the stock. Many institutional investors and mutual funds do not invest in stocks worth less than a set price, often $1 or less. Boosting the stock price, even artificially, can increase purchases of the stock. 

Criticism of a Reverse Stock Split

Reverse stock splits carry a negative connotation. 

Companies that need to go through a reverse stock split in order to boost their share price risk alienating their current investors.

New investors may not be impressed, either. They might believe the company is struggling and view the reverse split as an accounting gimmick.

The Bottom Line

Reverse stock splits are generally received with skepticism if not downright pessimism from investors. They are seen as a sign that a company is in financial trouble and sees boosting its stock price artificially as the only way out.

They're not wrong, but in fact, a number of companies have been forced to reverse-split their stocks during a bad stretch only to make a genuine comeback in market value over time.

Correction - April 30, 2023: A previous version of this article misstated the effect of a reverse stock split. A reverse stock split has no direct effect on the total dollar value of a stockholder's shares but may lead to further losses due to the company's perceived financial weakness.