What is the Difference Between a Stock Split and Reverse Stock Split?

Apple (AAPL) made headlines recently for continuing to post strong numbers even amidst the COVID-19 pandemic. The company also announced that its Board of Directors approved a four-for-one stock split.

So what does this mean?

You might be under the impression that a stock split is a move utilized for companies that are in financial trouble, such as penny stocks, but that is actually a reverse stock split. So, what’s the difference between a stock split and a reverse stock split? Read more below to find out.

What happens during a stock split?

According to Investopedia, a stock split is “a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares.” In the case of Apple, for example, they are doing a four-for-one split. This means that a shareholder who has one share of Apple, which is trading around $400 will now have four shares valued at roughly $100. The company’s dividends will also be quartered to reflect the four-for-one split.

Why does a company choose to do a stock split?

So what’s the purpose of doing this anyway? According to Business Insider, this action has zero impact on the company’s fundamentals or overall value and is meant to appeal to a broader base of investors. However, the same piece notes that Amazon has chosen not to do splits for the opposite reason. The company believes that by maintaining a higher share price, which is now above $3000, it attracts more longer term investors and decreases volatility.

A company additionally will opt to do a stock split to provide greater liquidity for the stock, which makes it easier for buyers and sellers that choose to trade the stock. When the company’s share price is lower and there is more flexibility and traders buying and selling the stock won’t cause as much of an impact to the price.

A stock split, in this sense, is advantageous for both existing shareholders and those who wish to become shareholders. Let’s say you are a younger investor just signing up for a Robinhood account. Your hope is to pick up a share of a blue chip company. Will you look at the newly $100 a share Apple or $3,000 a share Amazon? The choice is clear. You don’t have $3,000 to spend. This is the angle Apple is going for in this latest split.

What is a reverse stock split?

If you came into this piece expecting a stock split to be something negative, you were probably thinking of a reverse stock split. According to Investopedia, a reverse stock split is “type of corporate action which consolidates the number of existing shares of stock into fewer, proportionally more valuable, shares.

The process involves a company reducing the total number of its outstanding shares in the open market, and often signals a company in distress.” Basically, a reverse split reduces the number of shares owned by each shareholders but in exchange for a higher value share.

So, for example, let’s say a company is valued at $2 dollars a share. If the company did a 1 for 5 reverse stock split, in theory, one share would go from $2 dollars a share to $10 a share. A shareholder holding five shares of the company would now have only one share valued at $10 instead of five at $2 a share.

Why do companies do reverse stock splits?

News of a reverse stock split is rarely greeted as good news by a shareholder or the financial media, but sometimes it is a necessary step. For example, many major stock indexes require a minimum share price to maintain compliance. The NASDAQ will threaten delisting if a company’s share price falls under their $1.00 minimum for an extended period of time. Companies want to maintain their status on major stock indexes. If a company loses its place on a major index, it becomes less accessible to a common shareholder as it is then transformed into an OTC stock.

One example of this scenario is Rite Aid. In 2019, Rite Aid’s stock was struggling and stubbornly could not seem to get back over a $1.00 a share. With the company trading under $1.00 a share for an extended period of time, they were threatened with delisting from the New York Stock Exchange (NYSE), which would be a critical blow. The company did a 1-for-20 reverse stock split to maintain compliance. As of August 2020, the company is trading around $15 a share, prior to the split it was trading around $.70 a share. When you divide $15 by 20, you realize very little has changed with the value of the company’s shares in the last year, but $15 sure sounds a heck of a lot better than $.70.

Another reason for a reverse stock split is many institutional investors and mutual funds have their own internal policies against taking positions in stocks that trade below a certain price. A company that trades for under $5 a share by rule is technically considered a penny stock. A stock is definitely perceived as stronger and a more attractive buy if it has a high number of institutional investors.

Is a reverse stock split a bad sign for a company?

Typically, it is not a good sign when a company performs a reverse stock split.

Often, the price shoots up quite high briefly and there is a large sell off after. Sometimes, companies will also do reverse stock splits when they intend to sell off a division of their company to make the value appear higher. Typically, one can conclude things are in rough shape during a reverse stock split, but who knows, there are always exceptions. Novavax did a 1-for-20 reverse stock split in May 2019 after trading for pennies. Now as it emerges as a lead contender for a COVID-19 vaccine, it trades around $140 a share.

However, in most cases, if a company is even rumored to be exploring a reverse stock split, it’s generally a sign to steer clear.


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