Reverse Stock Splits and Stock Splits Explained

Apple shares are going to split 7 to 1 on the close of business this Friday.  Is this good or bad news for Apple shareholders?  I thought I’d republish this post that explains how stock splits (and reverse stock splits) work to help shed some light on this upcoming event.

Stock splits and reverse stock splits can be confusing. Are they a good or bad? Do they have any meaning at all? Should you buy stocks that are about to split? Is that a smart way to buy stocks or should you avoid stocks that are about the split? Let’s find out together.

How Do Stock Splits And Reverse Stock Splits Work?

Let’s first consider the stock split. With this maneuver the company you currently hold shares in takes back your old shares and gives you 2 or more new shares for each old share you own. In the case of the upcoming Apple split, investors will receive 7 new shares for each old share they hold.  Then investors reduce the cost basis of the new shares accordingly.  That’s it. Nothing really changes.  No value is created.  Let me illustrate this by appealing to your sweet tooth.

Think of a delicious apple pie you just took out of the oven. You can slice it up into 2,3, 8 or 16 pieces. It doesn’t matter how many slices you cut. You still have the same amount of pie. The same concept explains stock splits.

Let’s say your own 100 shares in XYZ stock and you’ve done really well. You bought your shares at $50 per share and now the stock is trading at an amazing $500 per share. For illustration purposes, lets assume that there are 1 million shares outstanding.

The value of the company is $500 per share times 1 million shares – or $500 million. In other words, Mrs. Richie Rich could come along and buy all the outstanding shares for $500 million and own the entire company. Make sense?  Good.

Let’s get back to you.

Before the split, you would have to cough up a cool $50k in order to buy another 100 shares. Not many people have that kind of cabbage to put into one particular stock.  That is the key to understanding stock splits.

The board of directors of the company figure that if they can get the price down to $50 per share, more investors will come on board.  And if the demand for shares goes up so will the share price.  As a result, the board issues a 10 for 1 stock split. That means for every stock an investor holds now they’ll receive 10 newly issued shares. And after this split there will be 10 million shares outstanding rather than 1 million.

The value of the company is still $500 million of course.  If there are now 10 million shares, the stock price will be $50.  So you used to own 100 shares of a security valued at $500 for a total value of $50,000. Now you own 1000 shares valued at $50 each for a total value of $50,000. You see? Nothing has changed. Now, let’s go back and look at this from the company’s viewpoint.

Has this exercise created value? Not in the least. Maybe more investors will become willing to make an investment in XYZ. And that enhanced demand might push the value of the shares up for awhile. But the value of the company is $500 million before and after the split as I said. You can see that there is no reason to get excited about a stock split. It sounds snazzy but it’s a big nothing. Let’s look at reverse stock splits now. They are far more nefarious.

How Does The Reverse Stock Split Work?

Like the stock split, the reverse stock split creates nothing. But it does paints a very skewed picture of reality. Here’s why.

Let’s say you own 10,000 shares of ABC Corporation. Unfortunately, ABC has fallen on hard times. The stock price is in the basement – it’s trading at $.50 per share. Your 10,000 shares are only worth $5000. The company has 10 million shares outstanding as well but since the shares are trading at only $.50 a share, the entire company is only worth $5,000,000. Peanuts.

As a long-term investor, you’ve witnessed the share price dive from $20 a share to $.50 . You know that the company is in trouble. Other investors realize this as well. Nobody is buying ABC – nobody. It’s generally understood that once the share price of a stock dips below $10 the company could be in trouble. At $.50 per share, this company is on life support and the doctors are about to pull the plug.

The board of directors realizes how dire the situation is. In an effort to drum up some interest in the stock, they decide to do a reverse stock split. This is the exact opposite of the stock split. Rather than giving you a multiple of the shares you currently own, they take back your old shares and give you fewer shares of the new securities. So for this example, the company might call in all the outstanding 10 million shares and issue 1 new share for every 20 old shares investors hold.

At the end of these shenanigans there are only 500,000 shares outstanding and they will be worth $10 per share. That’s because the “pie” hasn’t changed. It’s simply been cut up into fewer pieces. The company is still only worth $5,000,000. That being the case, why has the board of directors gone to all this trouble?

They realize that investors are frightened of buying shares trading below $10 per share as I mentioned above. By performing this reverse stock split magic, the price per share jumps from $.50 to $10. As a result, investors perceive less risk and they become more willing to invest.

Do you see the danger here? People think they are buying a $10 stock when in fact they are buying a $.50 stock. The risks are much higher than most investors perceive.

Stock splits are nothing more than smoke and mirrors. They don’t create any real value. If you own a stock and it does a stock split or reverse stock split, it might be time to look for a different investment.

How do you stand on this?  Are you looking for stocks that are about to split or do you split when your stock does?