What can investors do when a stock becomes worthless?

Stocks are one of the most popular and widely traded financial instruments in the world. They represent ownership shares in publicly listed companies in various sectors.

However, investing in stocks also involves risks, including significant stock price fluctuations due to a variety of factors.

At times, the unthinkable happens – a stock's value plunges to zero, leaving investors holding the bag.

Investors in Bed Bath & Beyond discovered this the hard way. In just two years, the company’s stock price fell precipitously from a multiyear peak of $35 in January 2021 to zero when the US-based retailer filed for bankruptcy on April 23.

In the annals of financial history, there exist sobering precedents where hapless investors watched their stocks spiral into the abyss of near or complete worthlessness.

Some of the most notable include Lehman Brothers, Enron and, more recently, electric vehicle manufacturer Nikola Corporation. All are stark reminders that business fortunes can crumble and turn investors' money into dust.

Here’s an explainer on why stocks can lose all their value, the implications for investors and what options they have in such a scenario.

Why stocks fall to zero

A stock price is determined by the supply and demand equation in the market. The higher the demand, the higher the price of the stock.

Conversely, if more people want to sell a stock than buy it, the price will fall.

“When demand for a companies’ common stock is low, then shareholders may be tempted to sell their shares and eventually the market is only left with supply and no demand,” says Christopher Brown, vice president of investments at Synovus Private Wealth Management.

“This may lead to a corporate restructure or eventually bankruptcy protection for the business.”

When a publicly traded business goes bankrupt, the common stock shares effectively become worthless.

The demand for a stock is influenced by various factors, such as the company's financial performance, growth prospects, capital management, competitive advantage, industry trends, economic conditions and investor sentiment.

For example, a company may face bankruptcy or insolvency due to poor management, corporate fraud, legal troubles, weak financial results or external shocks such as a pandemic or a natural disaster.

This can result in a loss of confidence and trust among investors, creditors, customers, suppliers and employees, leading to a sharp decline in the stock price.

Warning signs

They may be hard to detect for the average investor, but there are warning signs that could indicate a stock is at risk of dramatically losing its value.

“This may start as a long and slow process of declining prices and decreasing volume of the trading of the stock shares in the marketplace or it can be a fast crash like we saw over the past month with a few of the regional bank stocks [Silicon Valley Bank's parent SVB Financial Group, for instance],” says Mr Brown.

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Liquidity, also known as trade volume, for a company's stock is paramount. It’s essentially the number of shares a stock has traded over a certain period of time.

Trade volume is one of the many technical trading indicators on when to buy or sell stocks, says Mr Brown.

A lower trading volume indicates “a liquidity trap and not having a buyer on the other end of your stock sale”, he says. It could lead to decline in the stock’s value, he adds.

Here are some classic signs to look for:

Financial distress: Declining revenue, mounting losses and growing debt are all red flags. Negative cash flow and a high debt-to-equity ratio indicate potential financial instability.

Incompetent management: Poor leadership can result in strategic mistakes, inefficient allocation of resources and operational failures. Investors should closely study the management's track record, transparency and communication with shareholders.

Legal or regulatory issues: Lawsuits, investigations or regulatory actions can severely impact a company's financial well-being.

Erosion of competitive advantage: Increasing competition, disruptive new technologies or shifting market trends can erode the market position and profitability of a company.

Industry headwinds: Investors should monitor industry trends and the company's ability to navigate challenges. Companies in sectors that are susceptible to economic downturns may be particularly vulnerable.

Loss of investor confidence: Sudden stock price declines could be triggered by negative news coverage. Loss of key customers could also shake investor confidence and trigger a downwards spiral.

Thorough research, scrutiny of financial statements and observing industry trends could help to identify warning signs early and reduce the risk of investing in stocks heading south.

What happens to investors holding stocks during a free fall?

When a company goes bankrupt and its stock falls to zero, the implications for investors can be dire.

In the event of bankruptcy, a company’s assets are liquidated to repay debts and obligations.

Shareholders may receive a nominal amount, but it is unlikely to cover their initial investment. In some cases, the entire investment may be wiped out, leaving shareholders with worthless stock certificates.

“In bankruptcy proceedings, priority is given to creditors, bondholders and other stakeholders before common shareholders receive any distribution,” says Mr Brown.

“This is an offer that is mostly reserved to debt holders of the company due to the contractual obligation of the company to its debt holders.”

Common stock shareholders are last in the pecking order of a company’s overall capital structure.

“Senior secured bondholders of the company are at the top of the capital structure food chain followed by debenture debt, preferred stock and common stock shareholders,” Mr Brown says.

When a company’s business is struggling and is forced to officially file for bankruptcy, the stock price tanks to zero or several pennies.

It leaves investors facing the difficult choice of either holding on to the shares or cutting their losses: a losing proposition either way.

Making money when stocks nosedive

There are rare instances when investors can potentially make money when a stock becomes worthless.

One possibility is through short selling. If investors anticipate a stock's decline and take a short position, they can profit from the stock's downwards movement.

“Short-selling investors may buy ‘put option’ contracts to short sell, or bet on a stock price going lower in order to make money on a stock trade,” says Mr Brown.

Short selling involves borrowing shares, selling them at the current market price and repurchasing them at a lower price to return them to the lender. However, short selling carries the risk of market timing and can sometimes backfire.

“If short sellers get on the wrong side of a trade and the stock price moves up tremendously on unforeseen events, then your losses on a short sell could be infinite,” Mr Brown says.

He cites the pain suffered by short sellers in GameStop stock in January 2021, when a sub‐Reddit group called WallStreetBets organised retail traders to buy large amounts of long positions in the US video game retailer to squeeze short-selling groups out of their positions. The move cost short sellers millions of dollars.

These strategies require expertise, market knowledge and a sophisticated understanding of the risks involved.

Bottom line

While it's impossible to completely eliminate risk, investors can take steps such as diversifying their portfolio, conducting thorough research, keeping abreast of market-moving events and seeking professional advice to protect themselves and mitigate potential losses.

Remember, investing involves risk and there are no guarantees. While these strategies can help mitigate risks, it's important to carefully evaluate your individual financial situation and risk tolerance before making any investment decisions.