What happens to my stock if the company files bankruptcy?
You bought stock in a company you liked but now there are news stories about the company possibly filing for bankruptcy. So, what happens to your stock when a company files Chapter 11?
The unfortunate fact is that when companies file bankruptcy, stockholders almost always end up with nothing. Their stock becomes worthless.
Before I started MilleMoney, I was a Wall Street analyst who specialized in investing in companies that had a lot of debt. During my career, I’ve been involved in literally hundreds of corporate bankruptcies. In only one or two of those situations have shareholders received anything at all for their stock.
Think of a company as being similar to a house financed with a mortgage. The bank is the debt holder and the homeowner owns the equity in the house. Let’s say there's a recession. The homeowner defaults on his mortgage payments. The bank forecloses and ends up selling the house for less than the homeowner paid for it In this case, the bank has first dibs on any proceeds from the sale. The bank gets paid off first. If, and only if there is anything left over, does the homeowner get anything. In many cases, the home owner’s equity in the home is wiped out.
Now the bank will usually sell the house to someone else. That person finances the purchase with a new mortgage and a down payment. The new buyer creates new equity in that same house. But the original home owner doesn’t share in that equity.
When I was a junk bond analyst covering the auto industry in 2008-2009, I watched General Motors and many of its suppliers file bankruptcy. People who owned stock in those companies ended up with nothing.
Of course, that doesn’t mean you should avoid stocks! Over the last 32 years, less than 2% of companies have defaulted on their debt which is the thing that typically leads to a bankruptcy. During the last recession, 14% of companies that issued junk bonds ended up filing bankruptcy.
The coronavirus pandemic will undoubtedly impact many companies' revenues, earnings, and even possibly their ability to survive. What should you do to make sure you don’t end up holding some worthless stock?
- Check to see if the company whose stock you’re interested in has bonds, and if so, are they rated investment grade (AAA to BBB) or high yield (BB and below)? Companies whose bonds are rated high yield or junk have more debt and default at a higher rate.
- Check websites like Koyfin and MSN Money to find out a company’s “debt to equity ratio” and/or “leverage ratio”. A ratio under 3 is ideal.
- On Yahoo Finance, you can also check a company’s short percentage which is the percentage of its stock that is being shorted by investors who are betting the stock will fall. A short percentage over 10% could be an indication that active investors are worried about the stock.