Trading Below Cash: Reasons, Strategies, and FAQs

What Is Trading Below Cash?

The financial term trading below cash refers to when a company's total share value is less than its cash minus debts. Trading below cash occurs when a company's market capitalization is less than the amount of cash it has on hand and is most likely to happen when growth prospects are poor.

n some cases, stocks trading below cash can be attractive to value investors; however, there may be fundamental reasons miring such a company.

Understanding Trading Below Cash

Trading below cash may or may not be viewed as a negative depending on the company outlook. If a company is in the process of a turnaround, the stock may be trading below cash with the potential to succeed in the future. The opposite may also be true: if a company is trading below cash with weak growth prospects, it may be a sign that it is in trouble.

There's an old saying, "even a palace isn't worth much if it's on fire," meaning that a company's cash reserves aren't nearly as important as how fast the money is being spent (the burn rate).

Value Traps and Market Conditions

A company trading below its net cash per share seems a natural bargain buy. However, without digging deeper, investors can get lured into a classic value trap. This occurs when a stock is trading at low valuation metrics such as multiples of earnings, cash flow, or book value for an extended time period, relative to historical valuation multiples or a market multiple. The value trap is sprung when investors buy into the seemingly cheaply valued company at low prices and the stock continues to languish or drop further. Sometimes, things get worse before they get better—and sometimes they never do get better.

During a strong bull market, companies rarely trade below their cash values. But these situations do arise during sharp corrections, such as during the housing collapse of 2008. Certain sectors can also experience precipitous drops in market cap, such as the "tech wreck" of 2000-2002. Sectors and industries on the cusp of the "next best thing" at times trade below cash values. More recently these may have included cloud-based SaaS services, social networks, and increasingly anything tied to artificial intelligence.

Reasons for Trading Below Cash

As is to be expected, stocks rarely trade below cash value. However, under certain circumstances, such as those listed below, they may do so:

• In bullish markets, investors are willing to pay higher valuations for stocks, so they seldom trade below cash value. However, during a protracted bear market—when uncertainty reigns and valuations collapse—it is not unusual to find a significant number of stocks trading below cash value. For example, in October 2008, as global financial markets were caught up in an unprecedented sell-off, more than 875 stocks were reportedly trading below the value of their per-share cash holdings.
• Stocks trading below net cash may be clustered in a specific industry or sector if investors are extremely bearish regarding the prospects of that sector. For example, following the "tech wreck" of 2000 to 2002, a number of technology stocks were trading below the value of their net cash holdings.
• A stock may also trade below cash value if the company operates in a sector such as biotechnology, where a high "burn rate" (the rate at which cash gets used up for operations) is the norm and the payoff is uncertain. In such cases, this may signal that the market views the company's cash balance as only being sufficient for a few more quarters of operations.
• Stocks may also trade below cash value when there is a great deal of uncertainty about the valuation of assets and liabilities on the balance sheet. During the ferocious bear market of 2008, a number of banks and financial institutions traded below cash value for this reason.

Value or Impending Failure

​​The fact that a stock is trading below its cash value may be an indication that investors think the company is worth less as a going concern than it would be if it were wound up or liquidated (and the proceeds distributed to investors). This generally indicates an extremely pessimistic view of a company's prospects that eventually may or may not prove to be justified.

A stock trading below cash value may be a true value stock in situations where the pessimism surrounding its prospects is not justified. This could occur when a company is in the early stages of a turnaround and its business outlook is improving, or when a company is developing a drug or technology whose chances of success are viewed with undue skepticism by investors.

A stock trading below cash value may signal impending failure in cases where the company is struggling to raise additional capital before its cash runs out or when there are significant liabilities that may not be apparent on the balance sheet (e.g. a pending lawsuit or environmental issues).

Best Time to Invest

It can be tricky to know if a low-priced stock is a good investment or a costly value trap. There are, however, certain techniques that can be used to get a better handle on the situation. One way is to look at the book value of the company and, in particular, the net cash per share. This shows you how much shareholders could expect to receive in the case a firm went bankrupt and had to liquidate. A high net cash value per share would be indicative of a better value.

Another metric is to look at a firm's enterprise value (EV), which is similar to market capitalization but also takes into account the amount of debt on the balance sheet. In other words, it calculates the net value of the entire company. A low or negative enterprise value could be a red flag.

Once an investment has been identified, it may also be smarter to jump into stocks trading below cash value when overall market sentiment is positive and equities are in a firm bull market. This way, you can catch the overall trend.

Example of Trading Below Cash

Trading below cash can be illustrated by a company that holds $2,000,000 in cash reserves, has $1,000,000 in outstanding liabilities, and has a total market capitalization equal to $650,000. Its cash reserves less its liabilities are equal to $1,000,000 ($2MM - $1MM = $1MM), while the total value of its stock is only $650,000.