A reverse stock split is when a company decreases the number of shares outstanding in the market by canceling the current shares and issuing fewer new shares based on a predetermined ratio. For example, in a 2:1 reverse stock split, a company would take every two shares and replace them with one share. A reverse stock split results in an increase in the price per share.

stock split, on the other hand, is when a company increases the number of shares outstanding by splitting them into multiple shares. So, in a 2:1 stock split, each share of stock would be split into two shares, with the result being a decrease in the price per share.

Key Takeaways

  • A reverse stock split reduces the number of shares held by each shareholder into fewer, proportionally more valuable, shares.
  • A reverse stock split can be a red flag that a company is in financial trouble because it boosts the price of otherwise low-value shares.
  • Reverse splits are often motivated by a desire to prevent the company's shares or options from being delisted from exchanges and to boost public perception.

Are There Typical Ratios For Reverse Stock Splits?

Common share swap ratios used in a reverse stock split are 1:2 (1-for-2), 1:10, 1:50, and even 1:100. There is no set standard or formula for determining a reverse stock split ratio. Ultimately, the ratio chosen depends on the share price that the company wants to trade at on the exchanges.

Example of a Reverse Split

A company announces a reverse stock split of 1:100, meaning investors will receive 1 share for every 100 shares they own, but with a correspondingly higher value.

So if you owned 1,000 shares valued at 50 cents per share before the reverse split, you would own 10 shares at a price of $50 each after the reverse split. The value of your holdings was $500 before the split (1,000 shares at 50 cents each) and $500 after the split (10 shares at $50 each).

However, some investors can be cashed out of their positions if they own a small number of shares. For instance, if an investor owns 50 shares of a company that splits 100:1, the investor would be left with only half a share. In this case, the company would pay that investor the value of the 50 shares.

A reverse stock split causes no change in the market value of the company or market capitalization because the share price also changes. So, if the company had 100 million shares outstanding before the split, the number of shares in circulation would equal 1 million following the split.

Why Would a Company Do a Reverse Split?

1. To prevent its stock from being delisted by boosting its share price.

Being listed on a major exchange is considered an advantage for a company in terms of attracting equity investors. If a stock price falls below $1, the stock is at risk of being delisted from stock exchanges that have minimum share price rules. Reverse stock splits boost the share price enough to avoid delisting.

2. To boost the company's public image.

Typically, stock with a share price in the single digits is seen as risky. As its price approaches $1, a stock may be viewed as a penny stock by investors. There is often a negative stigma attached to penny stocks traded only over-the-counter and a company may try to avoid this label and protect its brand by engaging in a reverse split. 

3. To get more attention from analysts. 

A company may also wish to increase its share price to attract more attention from analysts and influential investors. Higher-priced stocks tend to attract more attention from market analysts, and this is viewed as good marketing.

4. To avoid delisting from options exchanges.

Typically, a company's share price must be greater than $5 for options to be traded on the stock. If a company's stock price falls too low for options to be traded on it, the shares might lose interest from hedge funds and wealthy institutional investors who invest billions of dollars in the market and hedge their positions via options. If portfolio managers can't hedge their long positions, due to delisting from an options exchange, they may sell the stock.

Other Considerations

Reverse stock splits can also be a negative signal to the market. As mentioned above, a company is more likely to undergo a reverse stock split if its share price has fallen so low that it is in danger of being delisted. As a result, investors might believe the company is struggling and view the reverse split as nothing more than an accounting gimmick.

Companies must consider this before engaging in reverse stock splits. Management's job is to determine whether the benefits reverse stock splits bring outweigh the risk of potentially being spurned by investors.