What Is Watered Stock?
Let me explain what watered stock is: it refers to shares of a company that were issued at a much greater value than what the company's underlying assets actually imply, typically as part of a scheme to defraud investors. You should know that the last known case of this happened decades ago, since stock issuance structures and regulations have evolved to eliminate the practice.
This term likely comes from ranchers who would force their cattle to drink large amounts of water before market, making them seem heavier and fetching higher prices—it's a direct analogy to inflating value deceptively.
Key Takeaways
Understand that watered stock is an illegal scheme to defraud you as an investor by offering shares at deceptively high prices. It's issued at a higher value than it's truly worth, achieved by overstating the firm's book value. Once it's revealed, watered stock becomes difficult to sell, and if you do sell it, it's usually at a much lower price than what was originally paid.
Understanding Watered Stock
The book value of assets can be overvalued for various reasons, such as inflated accounting figures—like a one-time artificial boost in inventory or property value—or through excessive stock issuance via dividends or employee options. Back in the late 19th century, corporation owners often exaggerated claims about profitability or assets, then knowingly sold shares at a par value far above the real book value of underlying assets, leaving investors like you with losses while the fraudsters gained.
They accomplished this by contributing property to the company in exchange for stock at an inflated par value, which boosted the company's balance sheet value even though actual assets were far less. It often took investors a long time to realize they'd been deceived.
If you held watered stock, you'd find it hard to sell, and any sale would be at prices much lower than original. Worse, if creditors foreclosed on the company's assets, you as a holder could be liable for the difference between the booked value and real assets. For instance, if you paid $5,000 for stock worth only $2,000, you might owe the $3,000 gap if foreclosure happened.
Fast Fact
Daniel Drew, a cattle driver and financier, is credited with bringing the term watered stock into the finance world.
The End of Watered Stock
This practice essentially ended when companies were required to issue shares at low or no par value, often on the advice of attorneys aware of the liability risks for investors. You as an investor became skeptical of par value representing true stock value, and accounting rules evolved to record the difference between asset value and low par as capital surplus or additional paid-in capital.
In 1912, New York permitted corporations to issue no-par-value stock and allocate incoming capital between capital surplus and stated capital on ledgers, with other states following soon after.
Other articles for you
A retirement money market account is a low-risk, liquid option within IRAs or 401(k)s for temporarily holding cash before investing in higher-return securities.
Long-term incentive plans reward employees for achieving goals that boost shareholder value and promote company growth.
Legal tender is the officially recognized currency that must be accepted for debts and obligations in a country.
The Kenney Rule is a financial ratio used in insurance to assess solvency by targeting a 2-to-1 balance between unearned premiums and policyholders' surplus.
A stock screener is a tool that helps investors filter stocks and ETFs based on custom criteria to identify trading or investment opportunities.
A common size financial statement converts financial data into percentages for easier comparisons across companies or periods.
Monopolistic markets occur when one company dominates, controlling prices and output due to high barriers to entry and lack of competition.
The revolving door describes the cycle of high-level employees moving between public and private sectors, raising concerns about influence and conflicts of interest.
A bank holding company is a corporation that owns and controls banks without providing banking services itself.
A stop-loss order helps investors automatically sell a security at a predefined price to limit potential losses or secure gains.