The stock market can be a wild ride, and no one knows this better than investors of EV maker Nikola Corp (NKLA). The company's stock, once valued at US$67 per share, has plummeted in value and now hovers below US$1.
The question on the minds of many investors now is: what happens when a company's stock falls to zero?
After all, this has happened before where stocks of Enron and Lehman Brothers stocks fell precipitously to or close to zero before being delisted by the exchange. More recently, it happened to Silicon Valley Bank's parent SVB Financial Group andBed Bath & Beyond (BBBY) whose stock fell to 71 cents and 28 cents, respectively, before trading was suspended.
Here is a guide that explains why stocks may plummet to zero and what it means for investors:
When a Stock Hits Rock-Bottom
If a stock falls to or close to zero, it means that the company is effectively bankrupt and has no value to shareholders.
“A company typically goes to zero when it becomes bankrupt or is technically insolvent, such as Silicon Valley Bank,” says Darren Sissons, partner and portfolio manager at Campbell, Lee & Ross.
On rare occasions, a stock’s value could fall to zero due to regulatory freezes imposed on a company for illegal activity or regulation breaches.
A company’s stock may lose all its value for a variety of other reasons, such as poor management, weak financial performance, corporate fraud, or external factors such as economic downturns or industry disruption.
A publicly traded company exhibits several signs of distress well in advance of declaring bankruptcy.Some of these signs include “over-leveraged balance sheets, erratic share price trading and lots of insider sales, that is, management getting out,” says Sissons.
Significant and persistent declines in profit and revenue, negative auditor reports and debt rating agency comments are also key red flags, “although, on these latter two groups, there are many instances in which they failed to capture the obvious data,” he warns.
Impact on Investors After Bankruptcy
For investors who own shares in a company that goes bankrupt, the equity is wiped out, rendering their investment worthless.
Big stock exchanges set limits on how low a stock can go before they take it off their platform. Typically, if a stock's price stays under one dollar for a certain number of days, the exchange will remove it from their listings. Once delisted, it becomes an over-the-counter (OTC) stock that speculators can buy and sell on alternative exchanges.
“Once the failing companies fall below minimum trading thresholds, market makers do not make a market in the name,” says Sissons, adding that “you may see a name kicked from the big TSX board to the Venture Exchange.”
When a company goes bankrupt, debt investors switch to an "as converted" basis and essentially become owners of the company, Sissons notes. "As converted" basis refers to the situation where debt investors or bondholders have the option to convert their debt or bonds into equity shares of the company. This means that debt holders become equity shareholders, and “control of the firm then falls to the most senior debt instrument,” says Sissons.
Making Profits from Sinking Stocks
Is there an opportunity for investors to make money when a stock price goes south? According to Sissons, yes. "You can buy the bonds, which are likely trading at a discount," he says. "If the firm is capitalized as 50% debt and 50% equity, then the value of equity drops to zero, so the [holders of] 50% debt control the firm and convert [the debt] to equity. The company then becomes debt-free in effect."
Alternatively, investors can buy puts or short the company.
Can a stock ever rebound after it has gone to zero? Yes, but unlikely. A more typical example is the corporate shell gets zeroed and a new company is vended [sold] into the shell (the legal entity that remains after the bankruptcy) and the company begins trading again. “Some upside can be re-captured at that time, says Sissons, but adds, “On balance, the equity investment is typically completely lost.”
Final Word for Investors
Are companies in some sectors more susceptible to going bankrupt than others? “In theory,” Sissons says, “any company can become bankrupt, but in practice, it's typically mature companies that have too much debt.”
He points out that “high-growth tech companies that run continuous net losses and then run out of money are also at risk,” citing Canadian telecom giant Nortel, which collapsedand went bankrupt in 2009.
If for some reason you end up owning stock in a company that is not on firm footing, it is critically important to understand the risk going in and ensure the investment still remains appropriate for your strategy.
Sissons’ advice is straightforward: “Do not buy companies with bad balance sheets. Review the auditor and debt rating comments and read research” and analyst notes.
There is much to monitor, though, and it’s a time-intensive process. “If that work is burdensome then employ a professional to assist with wealth planning,” he asserts.
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