Companies like to do whatever they can to control the price of their stock. Sometimes company management will drive to boost quarterly numbers, sometimes it will create a marketing and public relations campaign to influence investors and sometimes it will change the number of company stock shares that are available through a reverse stock split.

[VIDEO] Reverse Stock Splits

The term reverse stock split is not one you will hear very often in the financial media, but it does creep up every once in a while when a company’s stock price is in trouble.

To understand what a reverse stock split is, however, you first need to understand what a stock split is.

Stock Splits

A stock split is a process whereby a company increases the number of company stock shares that are available and decreases the price per share by splitting the current shares into multiple pieces rather than by issuing more new stock.

For instance, in a 2:1 stock split, the company takes every one share of stock and splits it into two shares of stock.

Here’s an example. If a company has 1,000,000 shares of stock trading at $100 a piece, and the company executes a 2:1 stock split, the company would then have 2,000,000 (1,000,000 x 2 = 2,000,000) shares of stock trading at $50 ($100 / 2 = $50) a piece after the split. In another scenario, if a company has 1,000,000 shares of stock trading at $100 a piece, and the company executes a 3:1 stock split, the company would then have 3,000,000 (1,000,000 x 3 = 3,000,000) shares of stock trading at $33.33 ($100 / 3 = $33.33) a piece after the split.

In both instances, the number of shares changes, but the market cap of the company remains the same at $100,000,000 [(1,000,000 x $100 = $100,000,000) or (2,000,000 x $50 = $100,000,000) or (3,000,000 x $33.33 = $100,000,000)].

Now let’s look at reverse stock splits.

Reverse Stock Splits

A reverse stock split is a process whereby a company decreases the number of company stock shares that are available and increases the price per share by combining the current shares into fewer shares.

For instance, in a 2:1 reverse stock split, the company takes every two shares of stock and combines them into one share of stock.

Here’s an example. If a company has 2,000,000 shares of stock trading at $50 a piece, and the company executes a 2:1 reverse stock split, the company would then have 1,000,000 (2,000,000 / 2 = 1,000,000) shares of stock trading at $100 ($50 x 2 = $100) a piece after the reverse split. In another scenario, if a company has 3,000,000 shares of stock trading at $33.33 a piece, and the company executes a 3:1 reverse stock split, the company would then have 1,000,000 (3,000,000 / 3 = 1,000,000) shares of stock trading at $100 ($33.33 x 3 = $100) a piece after the split.

In both instances, the number of shares changes, but the market cap of the company remains the same at $100,000,000 [(1,000,000 x $100 = $100,000,000) or (2,000,000 x $50 = $100,000,000) or (3,000,000 x $33.33 = $100,000,000)].

Why Would a Company Execute a Reverse Stock Split?

Companies will typically execute a reverse stock split for one of the following three reasons:

1. Increase their share price to avoid being delisted from an exchange
2. Increase their share price to avoid being removed from a stock index
3. Increase their share price to avoid the “low-quality” stigma that is associated with penny stocks

Image courtesy James Sarmiento.