A reverse stock split is when a company decreases the number of shares outstanding and increases the price per share 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 stock split, on the other hand, is when a company increases the number of shares outstanding and decreases the price per share by splitting the current shares outstanding into multiple shares. In a 2:1 stock split, every 1 share of stock would be split into 2 shares.
Are There Typical Ratios For Reverse Stock Splits?
Common share swap ratios used in a reverse stock split are two-to-one, 10-to-one, 50-to-one and 100-to-one. There is no set standard or formula for determining a reverse stock split ratio. Ultimately, the ratio chosen depends on the stock share price that the company ultimately wants their shares to trade at on the exchanges.
Example of a Reverse Split
A company announces a 1 for 100 reverse stock split. All investors will receive 1 share for every 100 shares they own.
So if you owned 1,000 shares and the stock price was 50 cents, after the reverse split, you would own 10 shares at a price of $50 each. The value of your holdings was $500 before the split (1,000 shares * .50 each) and $500 after the split (10 shares * $50 each).
However, some investors can be cashed out of their positions if they own a small number of shares. For example, if an investor owns 50 shares of a company that splits 1:100, the investor would be left with only half a share, so 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 would also change. So, if the company had 100 million shares outstanding before the split, the number of shares 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 their share price. 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. Being listed on a major exchange is considered a major advantage for a company in terms of attracting equity investors and no longer being listed on a major exchange is considered a major disadvantage.
2. To increase its share price to boost the company's image. Typically, a stock in the single digits is seen as risky and as the price approaches $1 the stock may be seen as a penny stock by investors. A company may try to protect their brand by avoiding the penny stock label and engage in a reverse split. There is a negative stigma typically attached to penny stocks traded only over the counter.
3. To get more attention from analysts. A company may not be in danger of being delisted, but it may nonetheless wish to increase its share price to attract more attention from analysts and investors. Higher-priced stocks tend to attract more attention from market analysts.
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 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.