Stock splits are most commonly associated with positive news, as they typically happen when a stock has performed quite well, and they generally result in an increased number of shares owned by each investor. But those splits, officially called forward stock splits, are only one variety. It's also possible for a company to complete a reverse stock split, which works in the exact opposite way. Unlike forward splits, reverse stock splits leave shareholders with fewer shares, and they often result from situations in which a stock has lost a substantial amount of its value.
Here's a quick overview of what a reverse stock split is, why a company would want to do a reverse split of its shares, and whether a reverse split is a good or bad thing for investors.
What is a reverse stock split?
A reverse stock split is a situation where a corporation's board of directors decides to reduce the outstanding share count by replacing a certain number of outstanding shares with a smaller number.
Reverse stock splits work the same way as regular stock splits but in reverse. A reverse split takes multiple shares from investors and replaces them with a smaller number. The new share price is proportionally higher, leaving the total market value of the company unchanged.
Calculating the effects of a reverse stock split is easy. Simply divide the number of shares you own by the split ratio and multiply the pre-split share price by the same amount. For instance, say a stock trades at $1 per share and the company does a 1-for-10 reverse split. If you own 1,000 shares -- worth $1,000 at current prices -- you'll get one new share for every 10 old shares you own, or 100 new shares. Immediately following the reverse split, the stock price will rise tenfold to $10 per share. That will leave your smaller position still worth the same amount, as 100 shares multiplied by $10 per share equals $1,000. To be perfectly clear, a reverse stock split doesn't change the overall value of your investment -- at least not all by itself.
A real-world reverse stock split
Citigroup (NYSE:C) was one of the hardest-hit bank stocks among the financial institutions that survived the 2008 financial crisis. As a result, the bank's shares were trading for just a few dollars -- more than 90% lower than their pre-crisis high.
In 2011 the bank decided to complete a 1-for-10 reverse stock split. Prior to the split, shares were trading for about $4.50 each, and after the split, the share price was roughly 10 times greater.
Why do companies do reverse stock splits?
A company does a reverse split to get its share price up. The most common reason for doing so is to meet a requirement from a stock exchange to avoid having its shares delisted. For example, the New York Stock Exchange has rules that allow it to delist a stock that trades below $1 per share for an extended period. Plus, many institutional investors are not permitted to invest in stocks with share prices below a certain minimum.
Are reverse stock splits good or bad?
A reverse split isn't necessarily good or bad all by itself. It is simply a change in the stock structure of a business and doesn't change anything related to the business itself. That said, a reverse split is usually taken as a sign of trouble by the market.
In rare cases, a reverse split buys a company the time it needs to get back on track. For instance, a reverse split worked for internet travel giant Priceline, now Booking Holdings (NASDAQ:BKNG), which did a 1-for-6 reverse split following the internet tech bust. Since bottoming in late 2000, shares of the travel company are up by more than 6,000%. So it's fair to say that a reverse split can be an effective tool for struggling companies to use.
The reverse split itself doesn't result in any change in the value of an investor's position in a stock, because the smaller number of post-split shares is offset by the proportionally higher per-share price. However, a reverse split can certainly change investors' perception of the company. Stocks that go through reverse splits often see renewed selling pressure following the split, and the number of companies that emerge from reverse splits to produce strong long-term returns is small.
The bottom line on reverse stock splits
Despite the occasional success story, reverse splits aren't usually a good sign for a stock. Still, they don't have to be a death knell, either. Because reverse stock splits have no fundamental impact on a company, it's more important to look at the financial health of a stock to assess whether a reverse split is likely to work in the long run.