Can Stocks Go To Zero?

Investment in stock market is not without its own fair share of risks, and there have been instances galore of stocks losing all their value. Whether it’s a Coronavirus Black Swan event or an accounting fraud, companies can quickly do about turns in share price and head south. But can stocks go to zero?

The short answer is yes. In what seems like the blink of an eye, company valuations can plummet to less than the value of the paper their net worths are printed on. In other words, the price of a stock can fall to awfully low levels and hit the zero mark if the issuing company goes bankrupt and subsequently out of business.

How Can Stocks Fall To Zero?

When stocks fall, a mythical creature known as the short seller is accused of manipulating share prices lower. But the reality is far more mundane.

A stock becoming zilch can be excruciatingly painful so it’s important to know how it can get to such levels. First and foremost, you need to understand how a stock price is determined.

To put this in perspective, the price follows the law of supply and demand. If the stocks are in demand, the price will go up; similarly, it will slide if the demand is low (relative to supply).

In short, when there is a bid for shares at a certain price, demand exists. When all the bids evaporate, share prices fall to the next highest bid. If there are no bids, prices plummet.

It is important to note that the performance and quality of a company are the primary determinants of a stock’s value. If the company is doing well, generating good income and is fundamentally strong, the demand for its stocks will be high, which in turn causes the share price to rise.

On the other hand, stocks of a poorly performing company with weak fundamentals are bound to go southwards. If a company’s performance dips dramatically, the stocks will follow suit.

During times of fear or panic, like when the Coronavirus pandemic fears creep into the market, emotion causes prices to crash, but that’s generally a more temporary situation.

Fundamentals are what drive share prices to zero. Panics are what drive share prices lower in steep declines in a hurry but they generally don’t last.

What Happens If A Company Goes Bankrupt?

If a company goes bankrupt, the stock for all intents and purposes will be worthless as investors will see no value in it. On certain occasions, competitors may find value in assets and purchase them piecemeal. But for the most part a bankruptcy spells doom for a company.

A company can file for either Chapter 7 or Chapter 11 bankruptcy

A Chapter 7 bankruptcy means the company ceases operation and its stock is delisted from the stock exchange.

Its non-exempt assets are sold to compensate the stakeholders in the order of preference as prescribed by the law — creditors, bondholders, preferred stockholders, and lastly, common stockholders.

By the time the common stockholders’ turn comes, there is a high probability that there will be nothing left in the kitty for them. It is really a harrowing scenario as they end up losing all their investment.

In the case of a Chapter 11 bankruptcy, the company’s stock may continue to trade on the exchange, but it counts for little as spooked investors will frequently rush to get rid of the junk stock at whatever price they get.

The difference between Chapter 7 and 11 bankruptcy, in short, is that in the case of the former, all business activities of the company are halted, its stocks are delisted and assets are sold; whereas in Chapter11 bankruptcy, the shares are still traded at the investors’ risk anyway.

How Can A Stock Get To Zero?

At Enron’s peak in mid-2000, its shares were worth $90.75. They plummeted to $0.26, when the firm declared bankruptcy on December 2, 2001.

The company’s management fooled regulators with fake holdings and off-the-books accounting practices. Things quickly went downhill once the charade was discovered; investors and creditors found themselves clinging by their nails to a rapidly vanishing market cap.

The same thing happened with telecommunications giant WorldCom, which crushed by its $41 billion debt load, filed for bankruptcy, in what was termed America’s biggest corporate failure.

The company admitted to having made use of fraudulent accounting practices to inflate profits by nearly $4billion a month, by improperly reporting expenses as investment.

Can You Profit From Stocks Going To Zero?

At first glance, this may look like an incredulous question, even downright stupid to some. But believe it or not, you can immensely profit from it if you are holding a short position in it.  After all, this was the method employed by George Soros to pocket a cool 1 billion dollars.

Grappling with low interest rates and high inflation, the British government artificially tried to prop its currency to higher levels. It ultimately had to withdraw the pound from the European Exchange Rate Mechanism (ERM) after its position became untenable post losing billions of pounds in a desperate attempt to artificially maneuver its currency.

You may have started wondering by now as to what exactly is a short position. To put it in layman terms, shorting or short-selling is a speculative trading strategy, wherein an investor borrows shares speculating that the stock price will decline.

Investors going short borrow shares, sell them immediately, planning to buy them later at a lower price. They can then return them to the lender and whatever is the difference between the buying and selling prices is their profit. However, it must be noted that shorting carries a high level of risk with it, in fact it is much riskier than taking a long position, for the simple reason that the price of an asset (much to the speculators’ disappointment) can significantly go up in value.

So coming back to our question of anyone profiting from value of declining stocks, we now know that short-sellers can profit substantially from such a scenario. On the other hand, people holding a long position, i.e. buying stocks, can lose all their money if the company goes kaput.

Stocks That Run High Risks of Becoming of No Value

There never can be any zero risk when it comes to investing in stocks. However, there are stocks that are far more risky than others. We list here a few types of stocks that are more prone to becoming worthless.

Penny stocks

Stocks trading at extremely low prices are branded as Penny stocks. Such stocks generally trade on the OTC markets, such as the OTC Bulletin Board (OTCBB).

Earlier, stocks trading at $1 or lower were classified as penny stocks. However, the Security and Exchange Commission (SEC) now labels any stock trading below $5 as a penny stock.

Penny stocks suffer from high levels of volatility and scams, and the companies issuing them have little or no profitability.

Companies with Poor Business Models

Distressing though it might sound, stocks of big multinationals can fall to near-zero levels as well if the company indulges in unsound or unscrupulous business practices.

A prime example of it is the global financial services Lehmann Brothers, which filed for Chapter 11 bankruptcy in September 2008. The firm was heavily investing in useless mortgage-based derivatives, which dangerously exposed it to any downturn in real estate values.

How to Protect Your Money

The likelihood of a stock going to zero, especially if it is a big company with a sound business model, is pretty unlikely. However, there is always the possibility of a stock’s value declining, which means you may end up incurring a loss.

As a stock investor, you always need to be alert and well informed to ensure your investment is safe. The good news is that there are quite a few ways through which you can significantly cut down the risk of losing your hard-earned money. We discuss the most important method of mitigating risk below:

Diversification

It is never a good idea to put all your eggs in one basket. You should have a portfolio that involves buying several stocks from different industry sectors having low correlation with each other i.e. react differently to the same event. This makes sense because if one industry or sector is going through a bad phase, you can cover your loss if other sectors perform well during the same period.

Compare this with having a very limited investment portfolio, wherein you find yourself more exposed to the vagaries of stock markets.

The best way to go about it is to diversify your portfolio with a mix of stocks and bonds. This can shield you from a variety of risks, but is pretty capital intensive. The other option could be to buy an ETF that has a lot of non-related stocks in its basket.

For example, you have stocks of an airline operator and a firm that make hand sanitizers. The threat of a novel virus has caused airline stocks to tank, whereas the demand for hand sanitizers has gone up manifold. Thus, the loss incurred in airlines stock is compensated by stocks of firm making hand sanitizers.

One thing to note here is that though well-diversified stock portfolio can protect you from unsystematic risk (probability of loss associated with a unique industry or segment), it may fail to work its magic in case of systematic risk (risks arising out of macroeconomic factors).

So, to cover both types of risks, it is always better to invest in assets that do not correlate with stocks, such as government bonds, real estate, gold, etc.

Can Stocks Go To Zero? The Bottom Line

The price of a stock can fall precipitously, and in extreme conditions fall to zero, if the company issuing it goes bankrupt.

To recap, yes, a stock can lose its complete worth and become totally valueless. However, this drop to nothingness can either be good or bad, depending on the investor’s position.

If you are holding a short position, you can enormously benefit from it, and conversely, lose everything if you hold a long position.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.