When a company announces a reverse stock split, it can cause a lot of confusion for shareholders. What is a reverse stock split? How does it work? Why would a company do this? 

In this guide, we will answer all of your questions about reverse stock splits and help you understand what you need to know before they happen. We'll cover everything from how they work to the advantages and disadvantages of reverse stock splits.

If you're wondering if you should sell or buy before a reverse stock split happens, or just want to know more about them, we’ll find out.

What is a reverse stock split?

A reverse stock split is when a company reduces the number of shares outstanding by exchanging each share for a fraction of a new share. The total number of shares would be halved, but the price of each share would double.

How a reverse stock split works

The way a reverse stock split works is that the company's board of directors approves a certain ratio or exchange rate. For example, if the exchange rate is two-for-one, then each shareholder would exchange two of their old shares for one new share. 

The total value of the company would remain the same. The total value of an investment for the shareholders would also be the same. Essentially a stock split works by reducing the number of shares outstanding while maintaining the value of the company.

The process of a reverse stock split is as follows: 

1. The board of directors approves the reverse split and sets the exchange ratio. 

2. On the effective date, shareholders who own shares on the record date will have their holdings reduced by the exchange ratio.

3. After the reverse split, there will be fewer shares outstanding and each share will be worth more money. Of course, some paperwork and the appropriate shareholder notifications would be sent out in advance of the stock split. However, it is a fairly straightforward process. 

Reverse stock split example

Let's say a company has 100 shares outstanding and each trade at $50 per share. If the company did a reverse stock split two-for-one, it would have 50 shares outstanding and each share would trade around $100 per share. 

Why do companies do reverse stock splits?

There are a few reasons why companies might choose to do a reverse stock split. Each reason has its own strategic purposes and some companies may do a reverse stock split for one or more reasons. 

Here are the most common reasons for a company to go through with this corporate action: 

To increase the share price

If the share price has fallen below a certain level, doing a reverse stock split can increase the price per share. This might make the stock more attractive to investors and help raise capital

Some investors may stay away from lower-priced stocks because they are perceived as being riskier. A higher stock price might make the company seem like a safer investment

To boost investor confidence

If a company's share price is volatile or has been falling, a reverse stock split can make the stock seem more stable to investors. This might encourage people to invest in the company and help boost confidence in the company. 

Lower-priced stocks can have higher volatility because they are more sensitive to changes in the market. A reverse stock split can help reduce this volatility.

To be eligible for certain exchanges or indexes

There are some stock exchanges and indexes that have minimum requirements for a company's share price. If a company's share price falls below these levels, it might do a reverse stock split to increase the price and become eligible again. 

How do reverse stock splits affect the stock price and shareholders?

Reverse Stock Split

As a shareholder, you would want to know how a reverse stock split affects the share price. It is quite simple. The price per share will increase. The amount that it increases depends on the exchange ratio. The number of shares you own will also be reduced by the exchange ratio.

For example, if you own 1000 shares and the exchange ratio is two-for-one, you would end up owning 500 shares after the reverse stock split. If the shares were trading at $50 before the split, they would trade at $100 after the split.

Do shareholders lose money in a reverse split?

The total value of your investment would remain the same because the company's overall value has not changed, just the number of shares outstanding and the price per share. In the example above, you would own half as many shares but the price per share would double. 

This effectively evens out so that the total value of your investment would remain the same. While a reverse stock split doesn't directly affect shareholders' pocketbooks, it can have indirect effects. Some advantages can occur that do affect you as a shareholder. Let's explore the benefits and drawbacks in more detail.

Advantages of reverse stock splits

When it comes to reverse stock splits, some advantages can be good for shareholders. The main one is that it can raise the stock price. If a company's share price has fallen below $0.50 per share, for example, a reverse split could send the price back up to $5 per share (or whatever the new ratio is).

That could make it easier for shareholders to sell their shares at a decent price, or encourage more investors to buy the stock. Even though the return on investment won't be necessarily higher, it can help create the perception that the company is doing well. 

Another advantage is that reverse splits can make a company look more attractive to potential investors. A low stock price can be seen as a red flag, but a higher price might give the impression that a company is doing better and is therefore worth investing in. Of course, this isn't always the case - sometimes companies reverse split because they're in trouble and trying to appear more stable as mentioned above. 

With less shares outstanding, new investors can feel more confident that their investment will have a greater impact on the company. If a company has 100 million shares outstanding and you buy one share, your ownership stake is lower than if you own one share and the company only has 50 million shares outstanding. 

Reverse splits can also help a company meet the listing requirements of certain stock exchanges. This is a major advantage because being on larger exchanges can result in more exposure and liquidity. 

Disadvantages of reverse stock splits

The main disadvantage of reverse stock splits is that it can make a company look like it's in trouble. If a company is doing well, there's no need to do a reverse split. 

In fact, companies usually only resort to reverse splits when their share prices have fallen so low that they're in danger of being delisted from exchanges. This can give the impression that the company is struggling and not worth investing in.

Reverse stock splits can also result in higher transaction costs. If you dollar cost average into a position frequently, you might end up paying more per share after a reverse split. This is because you would be making more buys since the price is lower. 

Before a reverse stock split, a $100 monthly investment into a stock worth around $100 could be purchased once a month. But if the price per share drops to $50 after a reverse split, you would be able to purchase two shares per month. In this scenario, the commission fees would double because you are buying twice as often. 

Finally, it can make it difficult for investors with less capital to allocate to a position. If a company has done a one-for-ten reverse split, a stock would go from $100 to $1000. This can be outside the range of affordability for some investors, preventing them from buying shares. However, investors might be able to buy fractional shares instead of whole shares.

Should you sell or buy before a reverse stock split?

If you own a stock that's about to do a reverse split, you might be wondering if you should sell or buy before the event takes place. As with most things related to investing, there's no easy answer. It depends on your investment goals and strategies. 

If you're a long-term investor, a reverse split shouldn't have much of an impact on your decision to sell or hold a stock. If you're a day trader or swing trader, however, it's difficult to definitively say what you should do. 

It really depends on the circumstances and your own investing style. Some traders might sell before a reverse split because they think the stock price will fall after the event. Others might buy because they think the stock will rebound. And still, others might do nothing at all. 

If you're thinking of making a move before a reverse split, be sure to do your own research first. Consider the reasons why the company is doing a reverse split and whether or not you think it will be successful. You should also have a plan for what you'll do if the stock price moves in the opposite direction of what you anticipated. 

Is a reverse stock split good or bad?

Reverse stock splits can be beneficial for companies and investors, but they also have some disadvantages. They are neither good nor bad but rather a tool that can be used in certain situations. As an investor, the most important thing to note is that the value of the company and your investment will not be changed by a reverse stock split. 

Finally, it should be noted that reverse stock splits are not always successful. Sometimes, a company's share price will continue to fall after a reverse stock split. 

This can happen for several reasons, such as if the underlying problems that caused the low share price in the first place are not fixed. 

That's why it's more important to focus on undervalued companies with growth potential and strong fundamentals rather than the share price.