What Is a Reverse Stock Split?

A reverse stock split is a method used by public companies to immediately boost their share price. However, there are issues with reverse splits that investors need to be mindful of. This article will delve into the mechanisms and issues surrounding a reverse stock split. 

At the very basic level, a reverse stock split is the opposite of a stock split. And the best way to understand a stock split is to use an actual example. In mid-2022, Alphabet (GOOGL) completed a 20-for-1 stock split. Right before its shares were split, the price for a single share of GOOGL stock was roughly $2,250. After the split, the shares were priced closer to $110 apiece.

This is because on the split record date, stakeholders were issued 20 new GOOGL shares for each one they already owned. So, if a shareholder had 10 GOOGL shares before the stock split, they had 200 shares after. 

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In other words, the total share count was "split" by 20. It's sort of like cutting a pie into 20 slices. The pie size hasn't changed – there are simply more slices. 

Similarly, with Alphabet, its total market capitalization didn't change (i.e., the number of shares times the stock price), just its share price did.

With its stock split, Alphabet wanted to make its high-flying shares to become more accessible to retail investors. For example, it cost investors roughly $11,000 to buy 100 shares of GOOGL immediately following the stock split vs about $225,0000 before the split – a much more realistic amount for most folks to have available.

It also made call options, which rise in value with the underlying stock's rise, cheaper to buy.

What is a reverse stock split?

A reverse stock split is the exact opposite of a regular stock split. Again, let's use a recent example.

On August 24, 2023, AMC Entertainment Holdings (AMC) completed a 1-for-10 reverse stock split. That means that for every 10 shares owned, AMC stakeholders were issued one new share. If they previously had 100 shares, they now had just 10 shares.

In other words, the total share count was been reduced by 10 times. The "pie" was cut into 10 slices vs 100 slices.

Similar to a regular stock split, AMC's market cap wasn't changed, just the share price. So, whereas AMC was trading for $1.96 per share beforehand, its new share price before any market changes was $19.60.

The problem is AMC stock has fallen again and now trades for roughly a quarter of where it was immediately following the reverse stock split. This brings up a common problem with companies undergoing reverse splits: They often highlight problems or issues a company is currently experiencing.

Is a reverse split good for a stock?

Typically, the vast majority of companies that use reverse splits have very low stock prices. These are known as "penny stocks" and generally have a terrible reputation in the market. 

For example, penny stocks tend to be seen as high-risk and often have histories as being scams. They are also typically tied to troubled or failing companies that have no real assets or unique qualities. The companies hope that a reverse stock split will boost their share price and improve their reputation.

The problem is that the market often seizes on this situation to push the stock further down. After all, there's a chance for a bigger profit when shorting a $10 stock vs a $1 stock. A higher-priced stock is also eligible for options trading.

This can be a double-edged sword for a company. It means that put options, which rise in value as the stock price falls, become a viable play for traders who want to speculate on a stock's demise.

However, one unique advantage with a reverse stock split is that a company with genuinely positive developments can now highlight its progress to the market. Any good commercial news or events, along with the higher price, can help put it head and shoulders above the fray in the market.

Take Citigroup (C). The country's fourth-biggest bank by assets underwent a 1-for-10 reverse stock split in 2011, bringing its share price to $40 from $4. Citigroup now trades above the $50 per-share mark.

The bottom line is that investors should carefully study the underlying developments and fundamentals of a company that employs a reverse stock split.

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