Watered Stock

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Watered Stock?

The last known issuance of watered stock happened several decades ago. Watered Stock refers to those company shares issued at a price much higher than their intrinsic value, intending to dupe uninformed investors. However, the supervisory bodies introduced various regulations to structure the stock issuance process to end such malpractices.

Etymologically, the term was originally used to make the livestock drink large amounts of water right before selling them in the market. In this way, the animals gained extra weight because of the consumed water and looked deceptively heavier, allowing the breeders to earn higher prices.

Explanation

The companies can overstate or overvalue the book value of the assetsBook Value Of The AssetsBook Value of Assets is the asset's value in the books of records of a company or an institution at any given instance. Assets Book Value Formula = Total Value of an Asset – Depreciation – Other Expenses Directly Related to it read more via several unscrupulous methods. For example, false escalation in property or inventory value increased stock capital through the issuance of fake employee stock options or stock dividendsStock DividendsA stock dividend refers to bonus shares paid to shareholders instead of cash. Companies resort to such dividends when there is a cash crunch. Shareholders are allotted a certain percentage of shareholding.read more, etc. At times, the promoters of the companies also make exaggerated claims about their profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more to raise investor expectations. After all this, the promoters deliberately sell their stake in the companies at a par valuePar ValuePar value is the minimum value of a security set and stated in the corporate charter or its certificate by the issuer when issued for the first time.read more that is much higher than the book value of the underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more and make fortunes for themselves, while the unaware investors are left high and dry with a massive amount of losses.

Watered Stock

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Examples of Watered Stock

First, let us understand how watered stocks work with the example of a fictitious company.

Let us assume that the promoters of BNM Inc. had assets worth $5 million in the form of land, buildings, equipment, and inventory. The company then decided to go public and hence started inflating its property value so that its expected market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more went up to $15 million. So, effectively the company is overvaluedOvervaluedOvervalued Stocks refer to stocks having more current market value than their real earning potential or the P/E Ratio. Overvaluation of stocks might occur due to illogical decision making or deterioration in a Company’s financial health. read more by $10 million, and it exposes the investors to what is called watered stocks.

Now, let us look at some of the real-life examples of watered stock frauds from the past.

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Example #1

The period from 1866 to 1868 was the time when the infamous Erie War took place. The notorious trio of Daniel Drew, James Fisk, and Jay Gould defrauded Cornelius Vanderbilt. He wanted to acquire the Erie Railway Company and build a railroad empire because he realized that there were many business and financial opportunities available in the railway sector as it was booming after the American Civil war. The trio sold him watered stocks of Erie Railroad worth $7,000,000.

However, later the trio was forced to return most of the defrauded money and, in exchange, got back the company’s control. The company went through several other financial frauds before finally declaring bankruptcy in 1878 owing to continuous mismanagement, after which it was reconstituted as the New York, Lake Erie, and Western Railway Company.

Example #2

In1873, the Railway Commissioners of Illinois stated that stocks of railway companies worth $75,000,000 were watered, otherwise expected to generate $6,000,000 in profit for the shareholders every year. These malpractices were not confined to Illinois but were actively happening across all the states, mostly in New York, New Jersey, Pennsylvania, and the Pacific States.

An investigation uncovered that 60% of Central Pacific Company’s $100,000,000 stock capital was based on fictitious profits that the entity refused to share among the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more in the form of dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more. The company’s inflated revenue/ gross receipts and high profitability drove the stock performance.

Causes of Watered Stock

  1. Unsuccessful adoption of the depreciation policyDepreciation PolicyDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more
  2. Acquisition of a company’s possessions at a significantly higher price
  3. Purchase of worthless intangible assets at a much higher price.

Advantages

  • 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.
  • Usually, the company’s promoters make money from this information asymmetry as they are at the helm of the entire controversy.

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:

  • During the uncovering of the fraud, the liability of the creditor’s money falls on the Unaware holders of the watered stocks.
  • New or inexperienced investors struggle in a market marred by watered stocks. They cannot do detailed research and compute conclusive data.
  • 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.

Conclusion

So, as we all know, “All that glitters is not gold,” similar is the case with growing stock prices. As such, one needs a lot of experience and expertise to spot these watered stocks out of so many overvalued stocks. So, before investing in a company, it is crucial to analyze its operations to understand the fundamentals of the business and its growth potential.

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