Reverse stock splits boost a company's share price. A higher share price is usually good, but the increase that comes from a reverse split is mostly an accounting trick. The company isn't any more valuable than it was before the reverse split. Whatever value it has is just distributed over fewer shares of stock, thus increasing the price. So a reverse split can generally be taken as a bad sign for a company.
In a reverse split, a company cancels all of its outstanding stock and distributes new shares to its stockholders. The number of new shares you get is in direct proportion to how many you owned before, but the number itself will be smaller. In a 1-for-2 reverse split, for example, you would come out of the split owning one share for every two you owned previously. If you owned 1,200 shares, for example, then you would wind up with 600 shares. In a 1-for-3 split, you end up with one share for every three you owned, so you would emerge from the reverse split with 400 shares if you started with 1,200.
The company's market capitalization -- the total value of all its shares -- stays the same before and after the reverse split. Say a company has 10 million outstanding shares and a stock price of 50 cents a share, for a market cap of $5 million. It then executes a 1-for-4 reverse split, reducing the number of shares to 2.5 million. The company's value remains the same, at $5 million, so now each share is worth $2. If you owned 100 shares at 50 cents apiece before, now you own 25 shares worth $2 apiece. The total value of your investment remains the same: $50. Nothing about the company has changed except the number of shares available, and that by itself has increased the stock price fourfold.
Companies pull off reverse splits to keep their stock prices out of the cellar. In part, it's aesthetics and public relations: A stock price in the pennies-to-a-few-dollars range just looks bad. But there are also practical reasons: To remain listed on a major stock exchange, a company usually has to maintain a stock price above a certain level, often $1. In 2009, for example, financial giant American International Group was in danger of being pulled off the New York Stock Exchange when its stock fell below $2. The solution: a 1-for-20 reverse split that boosted the price above $20. In 2011, Citigroup executed a 1-for-10 split that took its stock from around $4.50 a share to about $45 literally overnight.
Charles Kaplan, president of the investment consulting firm Equity Analytics, told Bankrate.com, "It is usually a very negative sign when a company reverse splits their stocks." But how the market reacts often depends on what else the company is doing to reverse its fortunes. If it simply declares the reverse split and goes on with business as usual, investors may see the split as nothing more than a smoke screen, and the price may go right back to falling as they sell their shares. But if the split is accompanied by serious changes in management, structure or strategy, investors may give the company more time to right the ship.