Investors may have been puzzled to read that Pier 1 Imports (NYSE:PIR) decided to effect a 1-for-20 reverse stock split. What is a reverse stock split and how does it impact Pier 1's stock?

Pier 1's reverse stock split: A practical matter

A reverse stock split occurs when a company reduces the total shares outstanding on paper and simultaneously adjusts its stock price. For example, a company could effect a 1-for-2 reverse stock split, which would result in cutting its share count in half and doubling its share price. In this example, a shareholder who owns 100 shares at $10 per share would have their holdings adjusted to 50 shares at $20 per share. The total value of the stock doesn't change (100 x $10 = 50 x $20); it's just adjusted to reflect a reduced share count on paper.

In the case of Pier 1's announced reverse stock split, it has divided its share count by 20 after shareholders voted to approve the measure. As the table below shows, the company's share count was reduced to 4.2 million shares outstanding from 84.9 million shares, and its stock price was adjusted to $13.60 from $0.68 per share. The company did not exchange cash to make the change; it was merely done on paper to be reflected at brokerages and stock exchanges.

Metrics June 19, 2019: Pre-Split June 20, 2019: Post-Split
Stock price $0.68 $13.60
Shares outstanding 84,990,884 4,249,544
Market capitalization $57.8 million $57.8 million

The reverse stock split did not change the total value of Pier 1's market capitalization. Data Source: Pier 1 financial reports, Yahoo! Finance. 

Why would Pier 1 go through all this trouble just to make some cosmetic changes? Stock exchange rules required it to. The New York Stock Exchange (owned by Intercontinental Exchange) requires listed companies to maintain a share price above $1.00 per share. Therefore, in order for Pier 1 to maintain its NYSE listing, it had to get its share price higher, and a reverse stock split was the easiest way to do that.

Reverse stock splits vs. regular stock splits

Don't confuse reverse stock splits with regular stock splits. In a regular split, companies will increase the number of shares outstanding in order to adjust their stock price lower. Quite obviously, this is the opposite of reverse splits. As in the case of reverse splits, no cash is exchanged -- the changes are merely cosmetic.

Why would a company want to reduce the price of its stock? To improve a stock's liquidity by making it easier to trade. If a stock has a high share price -- say, $1,000 per share -- reducing the price of the stock to $50 per share could make it "more affordable" to small money traders and result in more trading volume.

A pink couch in a well-lit living room.

Image Source: Getty Images.

The signaling effect

Stock splits and reverse stock splits do not represent real changes to a business or its capital structure, but they do send a message to investors. A company with a high stock price may split its stock because it thinks the stock will remain at a high price or the price will climb even higher.

For Pier 1, a reverse stock split was the quickest and easiest way for the company to get its stock above $1.00 per share. However, the fact that Pier 1 had to reverse split its stock could signal that the company didn't think its stock price would naturally rise above $1.00 per share. This lack of confidence in the stock price can have a negative impact on investor confidence. In fact, Pier 1 has seen its stock price continue to decline since the reverse stock split was completed.

PIR Chart

PIR data by YCharts.

The continued slide in Pier 1's stock price cannot be solely blamed on the negative signal sent by the reverse stock split, though. A week after the split was effected, the company released a disappointing earnings report. However, as a general rule, reverse stock splits are not generally seen as a positive indicator -- and that seems to hold true in this case.