stock splits and reverse splits

In short

A friend of mine once called me, thrilled, because his favorite company announced a split and he thought he had just gotten richer. He had not, and I had the pleasure of explaining why. A stock split changes how many shares exist and what each one costs. It does not change what the whole company is worth. If you own shares, a split gives you more pieces, each priced lower, and the total stays the same. A reverse split does the opposite, giving you fewer pieces at a higher price. The broker handles the change on its own, so the owner does not have to act. The statement afterward shows the new share count. The IRS sets the tax rules for a plain split, and its publications explain how they apply.

The whole of it

What it is

I once watched two neighbors cut the same pie, one into four slices and one into eight. Nobody went home with more pie. That is a stock split in a nutshell. A company decides to divide its shares into smaller pieces, and each owner gets more of them in return.

You have probably seen the common version, a two for one split. If you held 10 shares and the company does a two for one split, you now hold 20 shares. The price of each share drops by half. Same pie, more slices.

A reverse split runs the other way. If you hold 100 shares and the company does a one for ten reverse split, you end up with 10 shares. Each one costs ten times as much. Fewer slices, but each one is bigger.

A friend of mine once asked why a company would bother with any of this. A split can make a very high priced share easier for small investors to buy in round lots. A reverse split can lift a very low price so the stock meets the listing rules of an exchange. Those rules belong to the exchange, such as the New York Stock Exchange or Nasdaq, and the company has to follow them or risk being removed.

How it works

If you are holding shares when a split happens, here is the order of events. The company's board of directors announces the split and sets a few dates. The record date decides who counts as an owner for the split. The effective date is when trading starts at the new price. Your broker adjusts your account without you lifting a finger.

If you are holding shares, the math is simple, and it is worth checking every time. Say a company announces a three for one split. A person with 40 shares ends up with 40 times 3, which is 120 shares. If the old price was $150 a share, the new price is about $150 divided by 3, which is $50. Before the split, the holding was worth 40 shares at $150, or $6,000. After it, the holding is worth 120 shares at $50, or $6,000. Nothing was gained and nothing was lost.

Sometimes a reverse split leaves an odd leftover. Suppose a person holds 25 shares and the company does a one for ten reverse split. That works out to 2.5 shares. Many companies pay cash for the leftover half share, and some brokers hold fractional shares instead. The company's notice to shareholders explains which rule applies.

The numbers, and where to find yours

Your own numbers live in two places. The first is your brokerage statement, which shows your share count and the price per share before and after. The second is the company's own announcement. Public companies file a notice with the Securities and Exchange Commission, and you can read it for free on the SEC's EDGAR database. Look for the Form 8-K, which companies use to report major events, and for the proxy statement if shareholders must vote.

Your cost basis also changes, and this one matters. Cost basis is the amount you originally paid, and it sets how much gain you report when you sell. A split spreads that same cost across more shares. If you paid $2,000 for 10 shares, your basis was $200 a share. After a two for one split you hold 20 shares, and the basis is $2,000 divided by 20, which is $100 a share. The total is still $2,000.

The IRS explains how basis works in Publication 550, called Investment Income and Expenses. Your broker usually updates the per share figure for you, but it is worth a look. Some limits and thresholds in tax rules change each year, so use the current figure, which the official source publishes each year from the official source when you need the cutoff between short term and long term treatment.

A worked example

Let me tell you about a woman named Marjorie, a schoolteacher in Ohio who owns 50 shares of a company trading at $400 a share. She paid $300 a share over the years, so her total cost was 50 times $300, which is $15,000. Her holding is worth 50 times $400, which is $20,000.

The company announces a four for one split. Marjorie now owns 50 times 4, which is 200 shares. The new price is $400 divided by 4, which is $100. Her holding is worth 200 times $100, which is $20,000. Same as before.

Her cost basis moves too. The old basis was $300 a share. The new basis is $300 divided by 4, which is $75 a share. Check it. 200 shares at $75 is $15,000, matching what she paid in the first place.

A few years later, the company stumbles, and its price falls to $2 a share. The exchange warns that it may be delisted, so the company does a one for ten reverse split. Suppose Marjorie still holds her 200 shares. She now owns 200 divided by 10, which is 20 shares. The price jumps to $2 times 10, which is $20. Her holding is 20 shares at $20, or $400. The same as 200 shares at $2.

Notice what the reverse split did not do. It did not fix the business. The price went up on the screen, but her $400 stayed $400. A company that sinks on the day before a reverse split is still the same company the day after.

Where it goes wrong

I have seen smart folks trip over this, and I count myself among them on a bad day. The first mistake is treating a split like a gift. It feels like free money because the share count grows. But more slices of the same pie is not more pie.

The second mistake is reading a low price as a bargain or a high price as a warning. A $10 share and a $1,000 share can belong to companies of the very same size. What matters is how many shares exist, and the share price alone says little. Market value is the price times the number of shares, so you can only compare companies by looking at both.

The third trouble is with reverse splits. Because the price jumps up, the chart can look healthy when it is not. A company in trouble may do one just to stay on an exchange. Read the company's explanation in its SEC filing so you know the reason, rather than guessing.

The fourth is paperwork. A friend of mine once got a small check for a leftover fraction of a share and did not know what it was. Such a payment is called cash in lieu, and the IRS explains how to treat it in Publication 550. The brokerage reports it on a tax form, and keeping the statements makes that form easy to match. Mistakes also creep in when basis is not updated. If the broker did not adjust it, the seller has to fix the figure before reporting a sale, or the tax bill will be wrong. It is an easy thing to miss. Early checking helps.

Questions to answer before you leave this page

Do you know how many shares you own right now, and what you paid for them in total? When your broker sends a notice about a split, will you read the dates for the record date and the effective date? After the split, does your statement show a new share count and a new basis per share that multiply back to your original cost? If a reverse split leaves you with a fraction of a share, do you know whether your broker pays cash or holds the fraction? Have you looked up the company's Form 8-K on the SEC's EDGAR database to see its own stated reason? And when you read about a split in the news, will you remember that the whole company is worth the same as it was the minute before?