Are Reverse Stock Splits a Signal to Sell?

Reverse stock splits are often seen as a sign of trouble at a company. What are they, and why are they concerning?

Chris DavisOctober 15, 2020
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Would you rather have two $50 bills or one $100 bill? If you answered "it doesn’t really matter," then you’re well on your way to understanding the immediate impact of reverse stock splits.

Here’s a quick rundown of what reverse splits are and what they could mean for your portfolio.

What is a reverse stock split?

Reverse stock splits occur when a publicly traded company deliberately divides the number of shares investors are holding by a certain amount, which causes the company’s stock price to increase accordingly. However, this increase isn’t driven by positive results or changes to the company. Rather, the stock price rises because of basic math.

During a reverse stock split, the company’s market capitalization doesn’t change, and neither does the total value of your shares. What does change is the number of shares you own and how much each share is worth. If you own 50 shares of a company valued at $10 per share, your investment is worth $500. In a 1-for-5 reverse stock split, you would instead own 10 shares (divide the number of your shares by five) and the share price would increase to $50 per share (multiply the share price by five). This is the opposite of a stock split.

How does this change immediately affect your investment? It doesn’t, really. Your investment is worth $500 either way.

Why companies perform reverse stock splits

The most obvious reason for companies to engage in reverse stock splits is to stay listed on major exchanges. On the New York Stock Exchange, for example, if a stock closes below $1 for 30 consecutive days, it could be delisted. A reverse stock split could raise the share price enough to continue trading on the exchange.

But there are other reasons. If a company’s share price is too low, it’s possible investors may steer clear of the stock out of fear that it’s a bad buy; there may be a perception that the low price reflects a struggling or unproven company. To fight this problem, a company may use a reverse stock split to increase its share price.

In either instance, a reverse stock split could be a red flag to investors, but this isn’t always the case. Here are two basic outcomes of a reverse stock split:

Positive. Often, companies that use reverse stock splits are in distress. But if a company times the reverse stock split along with significant changes that improve operations, projected earnings and other information important to investors, the higher price may stick and could rise further. In this instance, the reverse stock split was a success for both the company and its shareholders.

Negative. If the company doesn’t successfully improve its operations along with initiating the reverse stock split, its stock price could continue to slide, sparking even more concern over the company’s fate.

Can reverse stock splits be a signal to sell?

If a company in your investment portfolio announces a reverse stock split, you might wonder if or how you should react before the split takes place.

"Just as stock splits are a sign that a firm is thriving, reverse stock splits are an admission of a struggling firm — a huge red flag," said Robert Johnson, a chartered financial analyst and CEO at Economic Index Associates, in an email interview.

A 2008 study that looked at reverse stock splits from 1962 to 2001 backs up Johnson’s assertion. The study, conducted on behalf of the Financial Management Association International, found a "significant downward price drift and significantly lower earnings and operating cash flows" in the three years after a company’s reverse stock split. This, the researchers said, suggests the market tends to underestimate how poorly companies will perform post-split.

Just as stock splits are a sign that a firm is thriving, reverse stock splits are an admission of a struggling firm — a huge red flag.

Robert Johnson

Steve Sosnick, chief strategist at Interactive Brokers and a former trader with Lehman Brothers and Morgan Stanley, says investors would likely see the warning signs early on.

"Presumably, an investor would have noticed that the stock in question was already acting poorly, but if not, the announcement of a reverse stock split is usually yet another significant clue," Sosnick says.

But there are, of course, outliers. Citigroup is often used as an example: In 2011, the company underwent a 1-for-10 reverse stock split (and also reinstated its dividend) that brought its shares up from around $4, technically considered a penny stock, to over $40. Though the share price has bounced around over the years, it never again veered toward penny stock territory and was trading in the $70 to $80 range before the pandemic hit in 2020.

The split came after Citigroup reported in 2010 its first year of four profitable quarters since 2006, highlighting an important consideration: If a company is improving its earnings and cash flow, and is committed to making further improvements in the future, a reverse stock split may not spell disaster. But that may be the exception, not the rule.

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