by Watered stock referred to shares of a company that were issued at a much greater value than the value implied by a company’s underlying assets, usually as part of a scheme to defraud investors. The last known case of watered stock issuance occurred decades ago, as stock issuance structure and regulations have evolved to put a stop to the practice.
Watered stock is an asset with an artificially-inflated value. The term most commonly refers to a form of securities fraud in which a company issues stock to someone before receiving at least the par value in payment.
This term is believed to have originated from ranchers who would make their cattle drink large amounts of water before taking them to market. The weight of the consumed water would make the cattle deceptively heavier, enabling the ranchers to fetch higher prices for them.
Watered stock is shares in a corporation that are sold at a price higher than the value of the underlying assets. This situation can arise when the assets are grossly overvalued, usually through a manipulative scheme. The seller of the shares then pockets the proceeds and leaves investors with valueless stock.
The term comes from cattle ranching, where ranchers forced cattle to drink an excessive amount of water in order to sell them immediately thereafter at a weight-based price.
The book value of assets can be overvalued for several reasons, including inflated accounting values like a one-time artificial increase in inventory or property value or excessive issuance of stock through a stock dividend or employee stock-option program. Perhaps not in every single case, but often in the late 19th century, owners of a corporation would make exaggerated claims about a company’s profitability or assets, and knowingly sell shares in their companies at a par value that far exceeded the book value of the underlying assets, leaving investors with a loss and the fraudulent owners with a gain.
Criticism
Over the years the use of watered stock has been heavily criticised by various experts, such as Walter Rauschenbusch and George D. Herron. Some of the major criticism is as follows:
- New or inexperienced investors tend to struggle in a market marred by watered stocks. They lack the ability to do detailed research and compute conclusive data.
- During the uncovering of the fraud, the liability of creditors money falls on the Unaware holders of the watered stocks.
- In most cases, the investors are caught in a value trap, and the only way out is through the unloading of these stocks by incurring considerable losses.
Advantages
- Usually, the promoters of the company make money out of this information asymmetry as they are at the helm of the entire controversy.
- Ace investors may take advantage of the market misinterpretation regarding the stocks by selling the stocks at a highly overvalued price and booking huge profits.
