/ Q&A

Can a Stock Lose All Its Value?

Yes, a stock can lose all of its value. Companies that fall on difficult financial times can go bankrupt leaving the equity worthless. This can stem from a loss of customer demand, operating issues, mismanagement, or fraudulent activity.

There are often several warning signs along the way before this happens. Still, it is quite possible for a company to go bankrupt and its stock to plummet to zero.

Contemplating if a stock can lose all its value is a legitimate concern for beginner and experienced investors alike. In this post, we’re going to explore the circumstances that could lead up to this worst-case scenario. To help prevent being blindsided by a sudden obliteration of an equity price, the investor can never perform too much research and due diligence.

The Dreaded B-Word

Getting into the stock market can be an exciting adventure, but it requires that we take the good with the bad. All stocks from the big blue chips to the tiny penny stocks carry some level of risk.

The nightmare scenario for us as stockholders is that a company goes bankrupt. Though it is much more likely that a smaller, less established company experiences this fall from grace, the forces of Mother market dictate that even the bigger guys are susceptible to bankruptcy.

The most likely scenario for a stock to reach zero is if a company fails to meet is debt obligations. As stated previously, this can stem from a loss of customer demand, operating issues, mismanagement, or fraudulent activity. Bankruptcy comes in two forms:

A company that declares Chapter 11 bankruptcy can have its stock continue to trade. This is a very dicey proposition; however, that often leads to a sharp downturn in the stock price. The more common occurrence is that a Chapter 11 company cancels its shares while it embarks on a business reorganization. Buying a stock involved in a Chapter 11 bankruptcy is about as risky as it gets because selling pressure often forces such a stock towards zero. Furthermore, even if a Chapter 11 company successfully emerges from bankruptcy, it usually issues new stock rendering former shareholders’ certificates worthless. The shareholder would have to buy into the new stock to give the company a second chance.

Chapter 7 bankruptcy, on the other hand, triggers an immediate cease-fire. A company shuts down its operations and its stock stops trading in the market. In this situation, creditors, or bondholders, will have first dibs on any funds that the company can scrape together by selling property or other assets. Stockholders are the caboose and would have the last claim on any remaining value after all creditors are paid off. It’s entirely conceivable that a giant goose egg shows up at the stockholder’s front door because the stock loses all of its value.

What Happens if it Does Hit Zero?

Falling to zero means that a corporation does not have any equity value whatsoever. Regardless of how it got there, the stock is rendered worthless. Even the kindest of investing souls are unwilling to take a chance on the stock. There is no investor recourse at this point. A stock that loses all its value is a rock bottom example of the inherent risks in equity investing. The investor is left to simply swallow some pride, learn from the experience, and move on.

With this said, even if a stock loses all its value, there may be a silver lining. The investor can claim the capital loss during tax time, offsetting capital gains in other stock positions to reduce tax liability. All is not necessarily lost. If this does happen, we accept the lesson – don’t put too many eggs in high bankruptcy risk stocks to avoid having a front porch full of squawking geese.

Should we Sell a Stock at a Loss?

So, when we are underwater on a stock, are we better off riding it out or selling at a loss? This can depend on several factors, including one’s personal financial situation and the turnaround prospects of the company.

If the stock represents a small percentage of the portfolio or the investor’s time horizon is long-term, and you believe intrinsic value is much higher than the price demonstrates, then hanging on may make more sense. Having a concentrated position in a losing stock or the potential to use the tax loss as a benefit may, on the other hand, be sound rationale for selling.

When Falling to Zero is a Good Thing

Aside from the glass-half-full mindset of the tax loss benefit, there is another scenario when a drop to zero is positive. Up until now, we’ve assumed that the investor has taken a long, or bullish, position in a stock.

Someone that has a short position in a stock hopes that the stock price will decline. Short sellers borrow shares of a company from a broker and immediately sell those shares. They then aim to buy back the shares at a lower price to return to the lender banking the difference as profits.

A stock that loses all its value is a dream scenario for the short seller. The stock would not have to be bought back and returned to the lender, and the short seller would have a 100% return on the contrarian investment.

With short selling, however, the potential for loss is greater than taking a long position. This is because a stock can only go as low as zero but could theoretically rise towards infinity. This can leave the short seller scrambling to buy back shares at an astronomical price well beyond where the short sale took place.

Can a Stock go to Negative?

Thankfully a stock can never dip into negative territory. Having a stock drop to zero is bad enough. When we buy a stock, we are taking a partial ownership position in a publicly traded company. It does not mean that our personal assets are on the hook should things go south at the company.

A shareholder will never encounter a situation where they would have to fork over money by virtue of owning a stock. Even the most volatile of penny stocks can never go below a price of zero. A stock can certainly become worthless, but the stockholder will never owe money beyond what they initially invested.

Biggest Stocks that Went to Zero

We often hear analysts and market pundits say that a stock “is heading to zero”. But does it really happen? The answer is, unfortunately, yes. Any stock can experience a sharp decline even to ground zero. We need to look no further than Enron and Worldcom, which both filed for bankruptcy and had stocks that became worthless. There are also several notorious examples of companies that once had multi-billion-dollar market caps and later became into penny stocks. Blackberry (BBRY), Alcatel-Lucent (ALU), and Fannie Mae (FNMA) are just a few examples. There are always stocks that are teetering on the brink of extinction. A look at the current universe of U.S. listed stocks shows that LabStyle Innovations (DRIOW) is trading around $0.03, and Seanergy Maritime (SHIPZ) can be had for 4 pennies a share.

Delisting, the D-Word

Bear in mind, however, that just because a company’s stock price reaches zero does not mean it is required to file for bankruptcy. It means that the equity component of the company’s business has been washed away. The company can, in response, choose to issue new shares, although it may obviously be a challenge to attract new investors.

Often, well before a company’s share price touches zero, the stock is often delisted from one of the major exchanges. This occurs when the exchange operator determines that the stock no longer meets the mandated requirements to be listed. For example, the New York Stock Exchange (NYSE) has a $4 stock price minimum, and any stock that falls below this threshold gets booted either temporarily or permanently. When this happens, the stock moves to the over-the-counter market (OTC), the preferred dwelling of many speculative traders. The stock can still be bought and sold on the OTC market. It can also be later relisted if the qualifying conditions are met. Delisting can occur for other reasons, including bankruptcy, in the event of a merger, or if a company decides to go private.

Doing the Reverse Splits

Another action that commonly occurs with stocks that are nosediving towards zero is a reverse stock split. This can serve as a warning sign to an investor that things are getting dire for the company.

A reverse stock split turns a particular share position into a smaller number of shares that still has the same value and same claim on a company’s equity. For instance, in a 1-for-10 reverse split, a 100-share position is converted to a 10-share position. The stock’s price is effectively increased by the same proportion. This strategy can be used by companies that are in danger of being delisted due to a low share price because it artificially boosts the stock’s price.

Keep in mind that this frequently just amounts to a company buying time as often the stock continues to slide back towards zero if business conditions don’t significantly improve. This is why some companies have a decorated history of multiple reverse stock splits as a way to remain on the major exchanges.

Can a Stock Come Back from Zero?

Ultimately, it’s the stock market’s participants that decide how much a stock is worth. Like the pricing of any other asset, it comes down to supply and demand. A stock that is in high demand will trend upward, while a stock that is low demand will see its price move lower. Demand for a stock, and the prices traders are willing to bid, is determined by the perceived future value of the company.

A falling share price means that a stock is losing value. When a stock gets delisted to the OTC market, it is said to trade on the “pink sheets”. Pink sheet stocks that approach or even reach zero still have an after-life in the highly volatile OTC market.

An OTC stock that has traders out there that perceive a troubled stock to have value may place a bid to purchase the stock. There are speculators for even the most depressed stocks who seek to act on the slimmest of recovery hopes and rumors. This can drive upward pressure in the stock and bring a seemingly finished stock back from the dead.

As long as a stock is actively listed on an exchange, it has the potential to move higher if a buyer is willing to pay more than zero. There must also be a seller that has lost all hope and is willing to part ways at the same price. But while there may be hope for a stock that hits zero, very often this presages an inevitable next move to worthlessness.

leo

Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.