A company performs a reverse stock split to boost its stock price by decreasing the number of shares outstanding, which typically leads to an increase in the price per share.

How a Reverse Split Works

During a reverse split, 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-10 reverse split, shareholders would receive one share of the company's new stock for every 10 shares that they owned. If a shareholder owned 1,000 shares before the split, the shareholder would own 100 shares after the reverse stock split.

Why Would a Company Perform a Reverse Split?

A reverse split would most likely be performed to prevent a company's stock from being delisted from an exchange. 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 can increase share prices to avoid delisting, and being listed on a major exchange is important for attracting equity investors.

A split might also be done to boost the company's image if the stock price has dropped dramatically. If the stock is trading in the single digits, it is likely to be considered a risky investment, particularly if the price is near $1 or considered a penny stock by investors. A reverse split might be engineered by a company to protect it's brand's image by trying to avoid the penny stock label. There is a negative stigma attached to penny stocks traded only over the counter.

A reverse split that sends the stock higher might draw more attention from analysts. Higher-priced stocks attract more attention from market analysts, and a favorable view from analysts is excellent marketing for the company. 

Key Takeaways

  • A stock split reduces the number of shares outstanding, which typically leads to an increase in the price per share.
  • A reverse stock split does not affect the company's value. Also, the total value of the stock held by an investor will not change after a reverse stock split.
  • A reverse split is often done to prevent a stock from being delisted or to improve a company's image if the stock price has dropped significantly.

The Effect of a Reverse Stock Split

A reverse stock split has no inherent effect on the company's value, and the company's total market capitalization is the same after the reverse split. The company has fewer outstanding shares, but the share price increases in direct proportion to the reverse stock split. The total value of the shares an investor holds also remains the same. If an investor owns 1,000 shares each worth $1 before a one-for-10 reverse stock split, the investor would own 100 shares worth $10 each after the split. The total value of the investor's shares would remain at $1,000. 

Implications of a Reverse Split

Reverse stock splits can carry a negative connotation. As stated earlier, 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 the reverse split is nothing more than an accounting gimmick.

However, a reverse split can be beneficial to a company by boosting its stock price to a level that enables it to transition from a penny stock traded over the counter to a stock listed on a major exchange. Such a transition attracts the interest of more investors.