Does a Reverse Stock Split Increase the Stock Price?

by Cam Merritt

A reverse stock split always increases the share price of the stock undergoing the split. In fact, boosting the stock price is usually the primary reason for the reverse split. The markets don't have a very high opinion of using reverse splits to boost prices, though, which is why "USA Today" markets analyst Matt Krantz once referred to the tactic as "something kind of sad" and "an admission of defeat."

Reverse Stock Splits

In a traditional stock split, a company replaces its current outstanding stock with a larger number of shares of new stock. It distributes the new stock to its shareholders in direct proportion to the number of shares they owned of the old stock. In a typical 2-for-1 split, for example, a shareholder who started out with one share of old stock ends up with two shares of new stock. A reverse split does just the opposite: The company replaces the current stock with fewer shares of new stock, distributed in proportion to shareholders' current ownership. In a 1-for-2 split, a stockholder who owned two shares of the old stock winds up with just one share of the new stock.

Price Effects

A reverse stock split (just like a traditional split) doesn't change the value of the company at all. The reverse split just spreads that value over fewer shares of stock. As a result, the per-share price of the stock must increase. Whereas before the company might have had 10 million shares outstanding at $1 apiece, it now has 5 million shares outstanding at $2 apiece. In both cases, the company's market capitalization is the same: $10 million. A reverse split also doesn't change any shareholder's stake in the company. If an investor owned 2 percent of the company before, that same investor owns 2 percent afterward; that ownership is just represented by a different number of shares. Before, she had 200,000 shares at $1 apiece; now she has 100,000 at $2 apiece.

Purpose

The increase in the share price isn't merely a side effect of the reverse split. It's usually the reason the company executed the split in the first place. There are two reasons for this. One is to simply make the stock look better to less-sophisticated investors. A stock trading for 50 cents might not be as attractive as one trading for $5, so a company might try a 1-for-10 split. The second reason is to avoid "delisting." Stock exchanges generally require a company to maintain a certain minimum share price -- usually $1 -- or risk getting kicked off the exchange. A reverse split can get the price up above the minimum.

Adjustments

On the day that a company reverse-splits its stock, the market automatically adjusts the price to account for the split. If the stock closed at $1 the day before, it will open at around $2. Investors generally recognize that the reverse split is primarily a bookkeeping measure, one that doesn't change the underlying fundamentals of the company. And Krantz writes that the reverse split could even discourage investors, pushing the price back down, as it signals that the company is resorting to accounting gimmicks rather than sound strategy to increase its share price.