Stock splits, either forward or reverse, shouldn’t change the actual value of a company’s equity. Stock splits simply cut the pie into smaller or larger slices, but the pie is the same size. So why do they do it?
In the case of forward splits, a company is often trying to get their stock price down to a level that’s attractive to investors. Berkshire Hathaway’s Class A shares at $357,000 each cost more than most houses, but their Class B shares at $235 can be bought by just about anyone with a 401k. As companies grow above $400 per share, they will often split to get prices down around the sweet spot of $100. There’s anecdotal evidence that this works, as both Apple and Tesla saw share prices rise immediately following their high-profile forward stocks splits in 2020. Some question the need for forward splits as brokers begin to allow investors to purchase fractional shares as small as $1. Still, forward splits remain common.
Reverse splits are a bit more complicated. Why would a company want their prices to be higher? In his dissertation for Florida State University, Barry Marchman identifies four reasons why a company would effect a reverse split.
1) Complying with listing requirements
Nasdaq, the New York Stock Exchange, and AMEX require that securities maintain a share price greater than $1. Companies that get below this amount, or fear they may in the next few months, may perform a reverse split in order to quickly raise share price and remain listed. Should they instead become delisted, they will have a harder time finding investors, as many brokers restrict the trading of over-the-counter stocks.
2) Reducing Transaction Costs
Higher share price has been correlated with reduced bid-ask spreads. In other words, people are willing to buy and sell at closer prices when the share price is high. This means slightly lower prices for those looking to buy and slightly higher prices for those looking to sell. This attracts investors, and is yet another reason companies might choose to perform a reverse stock split.
3) Allowing Purchasing on Margin
Many investors want to buy stock using someone else’s money. This is a common practice called “buying on margin,” and it allows investors to borrow up to 50% of the cost of the initial investment. For a stock to be marginable, however, it’s share price must be above $5. This is why so many reverse splits occur when the share price is below $1 (risk of delisting) and is set at a ratio that has the post-split price between $5 and $10 (marginable).
4) Reputation Enhancement
Even if the reverse split doesn’t affect margin or listing, just having a higher share price can make a stock seem more respectable. Investors might be more likely to take look at a stock trading at $2 than at $0.02, regardless of its exchange. The evidence is mixed on whether reverse splits actually improve returns, but sometimes perception of price-to-performance relationships is more powerful than evidence.
How to Profit off Reverse Splits
Say a company performs a reverse stock split at a ratio of 1 to 10. If you had bought 1 share before the split for $0.50, after the split you’d have 1/10 of a share, a fraction which historically could not be traded. To get around fractional shares, companies will sometimes pay the cash value of the fractional share, in this case $0.50. Other times, though, they will round you up to one full share. When they round up, the share you had bought for $0.50 is now worth around $5. You profit $4.50 at minimal at risk.
It’s nice, clean profit, but $4.50 is too small to get excited about. You can’t buy more shares at the same broker, as that just means you’ll get rounded up less. You can, however, purchase a single share at multiple brokers and let them all round up. There are at least 15 brokers that round up fractional shares from reverse splits.
If you’re interested in trading reverse splits that round up, subscribe to my newsletter and Twitter to get notified of upcoming splits the day they happen. Make sure your broker is one that rounds up fractional shares (some don’t round up as policy, while others charge fees). A running list of participating brokers can be found here along with sign up links to get you free stocks. If you’re interested in recent successful trades, they are posted here. More information about trading reverse splits can be found on the homepage here.