Reverse Stock Split Explained: What It Is & How It Works

A reverse stock split, as opposed to a stock split, is a reduction in the number of a company’s outstanding shares in the market. It is typically based on a predetermined ratio. For example, a 2:1 reverse stock split would mean that an investor would receive 1 share for every 2 shares that they currently own.

Impact of a Reverse Stock Split on Market Capitalization

A reverse stock split does not increase the market capitalizationMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies of a company – although the number of shares outstanding decreases, the stock price is adjusted accordingly in that the market capitalization of the company remains unchanged. In other words, shareholder valueShareholder ValueShareholder value is the financial worth owners of a business receive for owning shares in the company. An increase in shareholder value is created is unaffected by a reverse stock split. The following diagram illustrates the concept:

As illustrated, market capitalization must remain the same. Therefore, when the number of shares is halved (2:1 reverse stock split), the share price doubles to maintain the pre-reverse stock split market capitalization of $10,000,000.

Example of a Reverse Stock Split

Cathy is a new investor and currently holds 100 shares of ABC Company at $10 (for a total value of $1,000). ABC Company owns 100,000 shares outstanding and announces a 100:1 reverse stock split. Every 100 shares owned by shareholders are now converted to 1 share. How is Cathy’s investment in ABC Company impacted by a reverse stock split?

First, with 100,000 shares outstanding and a share price of $10, the market capitalization of ABC Company is $1,000,000.

Second, with a 100:1 reverse stock split, there are now 100 shares outstanding (100,000 / 100 = 100) post-split.

Third, we know that the market capitalization is unaffected by a reverse stock split. Therefore, the 100 shares now outstanding must add to achieve a total market capitalization of $1,000,000. Therefore, each share is now worth $1,000 ($1,000,000 / 100 shares outstanding).

Lastly, Cathy now owns 1 share in ABC Company (100 shares / 100). With each share being worth $1,000, Cathy’s investment in ABC Company is unchanged.

Reasons for a Reverse Stock Split

There are several reasons why a company would conduct a reverse stock split:

1. Minimum stock price imposed by exchanges

For exchanges, there is a requirement to remain above a minimum share price. On the New York Stock ExchangeNew York Stock Exchange (NYSE)The New York Stock Exchange (NYSE) is the largest securities exchange in the world, hosting 82% of the S&P 500, as well as 70 of the biggest, a company would risk being delisted if its share price closed below $1.00 for 30 consecutive trading days. Therefore, a reverse stock split may be used by a company to remain listed on exchanges and meet the minimum share price requirement.

2. “Improve” share price

In the United States, stocks that trade at less than $5 per share are considered penny stocksPenny StockA penny stock is a common share of a small public company that is traded at a low price. The specific definitions of penny stocks may vary among countries. For example, in the United States, the stocks that are traded at a price less than $5 are considered. For investors, shares that trade below $5 are typically deemed not investment grade. Therefore, a reverse stock split may be used to protect a company’s brand image and prevent the negative stigmatization of being labeled a penny stock.

3. Maintaining an acceptable share price after a spinoff

When a company decides to spin off its business, it may do a reverse stock split to maintain its company’s share price post-spinoff. For example, Hilton Hotels planned to spin off two businesses to its shareholders (Park Hotels & Resorts and Hilton Grand Vacations). On the same day, Hilton executed a 3:1 reverse stock split to keep its stock price in the same range as it traded before the spinoff.

Journal Entries for a Reverse Stock Split

The only journal entry required for a reverse stock split is a memorandum entry to indicate that the numbers of shares outstanding have decreased. A journal entry with debits and credits are not needed since the line items on shareholders equity do not change in a reverse stock split.

More Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Cost of Preferred StockCost of Preferred StockThe cost of preferred stock to a company is effectively the price it pays in return for the income it gets from issuing and selling the stock. They calculate the cost of preferred stock by dividing the annual preferred dividend by the market price per share.
• Dividend RecapitalizationDividend RecapitalizationDividend recapitalization (frequently referred to as dividend recap) is a type of leveraged recapitalization that involves the issuing of new debt by a
• Stock DividendStock DividendA stock dividend, a method used by companies to distribute wealth to shareholders, is a dividend payment made in the form of shares rather than cash. Stock dividends are primarily issued in lieu of cash dividends when the company is low on liquid cash on hand.
• Weighted Average Shares OutstandingWeighted Average Shares OutstandingWeighted average shares outstanding refers to the number of shares of a company calculated after adjusting for changes in the share capital over a reporting period. The number of weighted average shares outstanding is used in calculating metrics such as Earnings per Share (EPS) on a company's financial statements