What is a watered stock?

Watered stock was the term used to describe business shares that were issued at a price much higher than the value suggested by the business’s underlying assets, often as a component of an investor fraud scheme. Since the structure and rules governing stock issues have changed to end the practice, the last recorded instance of watered stock issuance was decades ago.

The origin of this word is said to have come from ranchers who forced their cattle to drink a lot of water before bringing them to market. The cattle would seem disproportionately heavier due to the weight of the water they had drunk, which would allow the ranchers to sell them for more money.

Understanding Watered Stock

Several factors may cause an asset’s book value to be overvalued, such as inflated accounting values—such as a one-time, fictitious rise in inventory or property worth—or an excessive distribution of shares via stock dividends or employee stock options. Maybe not always, but frequently in the late 19th century, business owners would intentionally sell their companies’ shares at a par value that far exceeded the book value of the underlying assets, giving investors a loss and dishonest owners a profit. They would make inflated claims about the profitability or support of their companies.

They would do this by giving the business property in exchange for inflated par value shares. As a result, even though the corporation would own fewer assets than those represented, its value would climb on the balance sheet. Investors would only discover they had been duped much later.

It was difficult for those who owned watered stock to sell their shares, and even if they could, the prices at which the shares were sold were far less than what they had originally cost. The holders of watered stock may be responsible for the discrepancy between the book value of the business and its real estate and asset values if creditors foreclose on the company’s assets. For instance, if creditors seized business assets and an investor paid $5,000 for stock worth $2,000, he may be responsible for the $3,000 difference.

Daniel Drew, a cattle driver and banker, coined the phrase “watered stock” for use in the financial sector.

The Watered Stock Epilogue

Companies were forced to issue shares at low or no par value, often on the advice of solicitors who were aware that diluted stock might expose investors to liability, effectively stopping this practice. The guarantee that a stock’s par value reflected its true worth caused investors to become cautious. Accounting rules were created to account for capital surplus or extra paid-in capital, which is the difference between the asset value and the low or no par value.

Soon after New York made it lawful for businesses to issue no-par value stock in 1912, other states quickly followed suit, dividing incoming capital into capital surplus and declaring capital on accounting ledgers.

Conclusion

• A fraudulent attempt to mislead investors by issuing shares at inflated prices is known as “watered stock.”
• By inflating the company’s book value, watered stock is offered at a price greater than its value.
• Once exposed for what it is, diluted stock is hard to sell and, when it is, usually sells for a fraction of what it was initially bought for.