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What Is a Reverse Stock Split, and How Does It Change Your Portfolio?

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What Is a Reverse Stock Split, and How Does It Change Your Portfolio?

What does it mean for investors when a company announces a reverse stock split? If you're familiar with stock trading, then you've likely heard of a forward stock split, which is a process that can leave investors holding more shares than they did before without having to make a purchase of more stocks. A reverse stock split is essentially the opposite and happens when a company decides to consolidate the number of shares it has available on the market.

But is a reverse stock split good news or bad news for your finances, and what exactly does it mean for your portfolio? Take a closer look into why companies perform these consolidations and how these actions affect investors.

What Is Reverse Stock Splitting?

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To best understand what a reverse stock split is, it's helpful to first define a forward stock split. During a forward stock split, a company divides each one of its shares into multiple smaller shares. This leaves investors with more shares of a stock than they'd originally purchased.

Say, for instance, that you held one share in a company, and that share was worth $300. If the company decided to do a 3:1 forward stock split, you'd end up with three shares, each of which would be worth $100. While the total value of your holdings in the company didn't change, your number of shares did. The idea here is that by lowering the price of its shares, a company hopes that more people will be attracted to invest in them and the share prices can continue to grow in the long run. A forward split makes shares of stock more accessible to people who may have been hesitant to invest before due to the higher previous costs per share.

In a reverse stock split, companies go the opposite route and combine existing shares into a smaller number of shares. Thus, each share becomes more valuable. In this case, imagine that you held four shares in a company, each of which was trading at $25. If the company announced a 1:4 reverse split, you'd end up owning only one share worth $100.

While neither a forward nor reverse stock split initially changes the value of an investor's holdings, each has implications that can affect the long-term strength of the investment.

What Does a Reverse Stock Split Signify?

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A forward split is generally considered good news and signifies that a company is doing well. Reverse splits, however, don't tend to be so popular among shareholders. While it's rarely considered good news, whether or not a reverse split is actually bad news often depends on the reason that the company decided to perform this action. There are a few common reasons companies opt for reverse splits.

Attempts to Legitimize the Company's Share Price

When a company is struggling, its share price usually reflects these difficulties — often by dropping. When a stock's price hits certain low points, it can be nearly impossible for it to draw the support of large, institutional investors. Given the fact that institutional investing is largely responsible for a stock price's movement, this can signal a problem as far as future growth is concerned. When a stock price dips to under $5, for example, it's considered a penny stock, and the odds are slim that institutions will even consider investing in it. A reverse split is a quick way to boost a stock's price in an effort to prevent the appearance that a company's finances are in trouble.

Avoidance of Delisting

Another common reason for the reverse split is the fact that, if a stock's price falls below $1 for a certain length of time, it may be removed from its exchange. This makes it much more difficult for people to trade the stock. To avoid delisting, a company may conduct a reverse split to temporarily boost the stocks' price in the hopes of recovering before it's too late. A company may also perform a reverse split due to impending bad news or poor performance that it anticipates will soon tank its stock price. By inflating the share price before the potential plunge, the company gives the stock more room to plummet before it reaches either penny-stock or sub-$1 status.

Lowering Transaction Costs

This is another tactic that goes back to an attempt to attract institutional investors. These types of investors prefer to buy large numbers of shares, which can become expensive on lower-priced stocks due to the associated per-share transaction fees. By combining a large number of low-value shares into a smaller number of higher-value shares, a company can make the prospect of investing look more attractive to institutions.

How Does a Reverse Split Impact Investors?

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The ways a reverse stock can affect shareholders largely depend on the company's reason for making such a decision. If you find that some of your holdings have been consolidated in a reverse split, you'll definitely want to find out why. While the reverse split isn't generally seen as a positive sign for a company, it's a move that's not without its pros and cons.

On the upside, a reverse split may keep a stock from plummeting to a price so low that institutional investors are unable to continue to buy or hold it. In this regard, the reverse split can help give investors more time to decide whether they want to stick with the stock rather than being forced out due to institutional dumping.

While a reverse split isn't always enough to keep institutions from selling shares en masse, it at least helps guarantee that they have an option. The obvious downside is that a reverse split isn't generally a move that companies make when they're performing well. It's often a sign of either poor performance or bad news on the horizon.

Mitigating the Effects of a Reverse Split

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What do you do if you're a shareholder in a company that pulls a reverse split? Again, the first task is to figure out why the company went this route so you can better anticipate the direction the stock may head. Have bad management decisions or poor performance led to a breakdown in stock prices? Or is the company simply navigating a temporary setback due to an event outside its control?

It could even be that the company in question is a spinoff of a larger, more successful company that wants to legitimize its stock prices. Once you understand the reasoning behind the reverse split, you'll be in a much better position to choose whether you want to hold your shares or sell.

If the company appears to be struggling due to financial difficulties, do you believe it stands a chance at making a comeback? Positive price reversals often come on the tails of the upcoming launch of a hot new product, new management or other good news, such as the approval of a trial drug for a pharmaceutical company. If you do foresee this possibility, then the stock may be worth holding onto.

If, however, there's no sign of a brighter future ahead, you may want to jump ship while you still can. If a company is obviously struggling and showing no signs of reversing, you don't want to lose more money than you have to.

Sometimes, things may not be clear either way. In this case, you can minimize your risk by scaling down and selling part of your shares while retaining others. You also have the option of setting a sell-stop or trailing sell-stop so that your shares will automatically trigger a sell order if the company's stock price drops below a certain price or drops by a certain percentage.