When a company splits its stock, it essentially changes the number of shares outstanding. This typically involves giving shareholders more shares for each share of stock they already hold. For example, in a 2-to-1 stock split, shareholders would get two shares of stock for each one they already hold, but the price of each share would be half as much. In a reverse stock split, shareholders get fewer shares, but each share is worth more. Companies usually do a reverse stock split to boost share price.
Reverse Stock Split
When a company reverse splits its stock, it consolidates outstanding shares. In a 1-for-5 reverse split, for example, each shareholder would get one share for each five shares he currently owns. The stock split does not dilute the shareholder's investment, however, because each new share would be worth five times as much as the old shares. Say, for example, that you owned 500 shares of a company worth $0.80 apiece. If the company reverse splits the stock 1-to-5, you would now have 100 shares worth $4 each.
Reasons for Reverse Split
When a company does a reverse stock split, it is nearly always an attempt to boost its share price. The company may believe its price is too low to attract investors, and its board of directors may be confident that it should be worth more. A company may also do a reverse stock split to avoid being delisted from a stock exchange because its low price falls below the exchange's minimum threshold.
While a traditional stock split is often seen as a sign of strength, a reverse stock split is usually a bad sign. There's typically a reason why a company's stock price has fallen into the penny stock range, and doing a reverse stock split to boost the price doesn't do anything to increase the underlying value of the company.
A reverse stock split may temporarily make a company's shares more attractive because of the higher price, but the outlook for these stocks usually is not good. Without a change in fortunes that led to the low stock price in the first place, the company likely won’t be able to sustain the higher price. A study published in the summer 2008 edition of "Financial Management" looked at the performance of more than 1,600 companies that had done reverse stock splits and found "statistically significant, negative abnormal returns" in the three years after the split.
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