A reverse stock split occurs when a publicly traded company divides the number of outstanding shares by a certain amount. This serves to decrease the number of outstanding shares and increase the price per share of those outstanding shares. This differs from a forward stock split where the number of shares increases, and the share price declines post-split.

Reverse stock split: What that means

With a forward stock split, a company increases the number of shares outstanding and lowers the price per share. With a reverse stock split, a company reduces the number of shares outstanding and boosts the share price.

An excellent illustration of a recent reverse stock split is General Electric. The company declared a 1:8 stock split back in July 2021. This corporate action increased the share price by eight times on the effective date of the reverse split and reduced the number of shares outstanding by dividing the pre-split total by eight.

Why companies do reverse stock splits

There can be several reasons for a company to embark on a reverse stock split.

Prevent being delisted

If a company’s share price gets too low, it could face the delisting of its shares by the stock exchange where the shares trade. Being listed on an exchange is important to ensuring public trust in a company and maintaining investor interest. A reverse split can be a quick way to push the share price above required levels for continued listing.

Boost the share price to enhance the company’s image

If a company’s share price falls into the single digits per share or lower, investors may look at the shares as a penny stock. The low share price may put the stock off-limits for some investors, especially institutional investors, which may be required by their charter to avoid shares with a low price per share.

Gain more attention from analysts and large investors

Once a stock’s share price falls too far, it may drop off the radar of influential stock analysts and institutional investors. In the latter case, institutions may shy away from stocks whose share price is regarded as too low.

Are reverse stock splits good or bad?

All things equal, a reverse stock split is neither good nor bad. However, they often carry a negative connotation as many of the companies doing them are countering a sharp drop in share prices.

“It is usually a very negative sign when a company reverse splits their stock,” says Charles Kaplan, president of the investment consulting firm Equity Analytics. He indicated that the market reaction is often dependent upon other steps the company may take to reverse the situation that has led to its lower share price.

What happens to your shares following a reverse stock split?

The total value of the shares — the company’s market capitalization — will be the same after the reverse split as it was prior to the split. The exception to this would be if the company decided to pay out as cash any fractional shares that would result from the reverse split.

If your shares are held by an online stock broker or other type of custodian, the transaction will be seamless to the shareholder and will be handled electronically.

There would normally not be any tax implications from a reverse stock split. One exception is a reverse split where cash payments were issued to shareholders in lieu of fractional shares. These distributions would be subject to capital gains or losses depending upon the shareholder’s cost basis and holding period. This of course, would not be an issue if the shares were held in a tax-advantaged retirement account like an IRA.

At the end of the day, investors should look at any announcement of a reverse stock split based on the unique issues and fundamentals of the individual company and its stock. Whether a reverse stock split ultimately works out to be a positive or negative for shareholders will depend on the situation surrounding the specific company.

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