Definition
Watered stock refers to shares of a company that have been issued at a value greater than its actual assets or earning power. It typically happens when a company’s assets are inflated or earnings are misrepresented causing its stock to seem more valuable than it truly is. Such a practice is generally considered fraudulent and unethical in financial markets.
Key Takeaways
- Watered stock refers to stocks that are issued by a company at a value much greater than its actual asset value. It’s often a result of overvaluation where the company’s asset value is inflated or its earnings are overstated.
- Issuance of watered stock can lead to stock market manipulation and fraud. It may seriously affect the company’s reputation and investor’s confidence in the market.
- The term originated from the old practice of making livestock weigh more by pumping them full of water before their weight was calculated for sale. Similarly, watered stock represents inflated and misleading company value.
Importance
Watered stock is an important finance term as it relates to both corporate and investment practices, highlighting potential risks within the stock market.
“Watered stock” refers to shares that have an inflated value, meaning the stock’s price is higher than the actual value of the company’s assets.
This situation can occur when a company’s assets are overvalued or when the company issues new stock to existing shareholders without an additional investment.
Either scenario can lead to a significant financial risk for potential investors.
For those buying or selling stocks, understanding the concept of watered stock is crucial to making informed decisions and managing investment risks.
Explanation
Watered stock refers to shares of a company that have been issued at a value far greater than the actual assets of the company, similar to the 19th-century cattle industry where ranchers would ‘water’ their cattle to increase their selling weight. The intention behind issuing watered stock is typically associated with creating an inflated perception of a company’s value without the requisite underlying assets or earnings.
Essentially, it’s an overcapitalization issue where the fundamentals of the company cannot justify the total stock value in the market. The purpose of watered stock is generally to attract investors by creating an illusion of a highly profitable and successful company.
By issuing stocks at a value greater than the company’s total assets, companies might seem more attractive to prospective or existing investors. However, it is essentially a deceptive practice as it falsely inflates the company’s worth.
Over time, when the true value of the assets becomes clear, the stock could fall significantly. Consequently, trading watered stock is considered unethical, and in many jurisdictions, it is also illegal.
Examples of Watered Stock
Enron Scandal: This infamous financial scandal of the 2000s is perhaps the most notable example of watered stock. Enron, an energy company, used complex and dubious accounting practices to overstate its profits and inflate the value of its stock. As a result, Enron’s stock was heavily overvalued. When Enron’s fraudulent practices were exposed, the company went bankrupt and its stock became essentially worthless.
WorldCom: WorldCom was a telecommunication company in the United States that also inflated its assets by nearly $11 billion through false accounting entries. The inflated financial statements created an illusion of successful growth and profitability, which pushed the company’s stock price higher. However, when the fraud was uncovered in 2002, the stock’s value quickly plummeted, causing massive losses for investors.
Bre-X Minerals: This Canadian-based company falsified data regarding their gold mining operations in the ’90s, which significantly overvalued the company’s worth. After independent companies discovered their deception, their stock value fell from a peak of CAD $
50 per share down to just mere pennies, making it one of the most notable examples of watered stock.
FAQs About Watered Stock
What is Watered Stock?
Watered stock refers to shares that a company issues with a value much greater than the value of the company’s assets. These stocks are often associated with inflation of a company’s value and are considered to have detrimental effects on the stock market.
What are the Consequences of Owning Watered Stock?
When a stockholder invests in watered stock, they risk the possibility of loss as the securities are overvalued. If the company is unable to justify the extra value through increased profits or expansion, the stock’s value will decrease, resulting in losses.
How is Watered Stock Identified?
It can be challenging to identify watered stock. However, potential investors can look for indications such as inflated asset values, overstated earnings, and high debt levels relative to equity. It is advisable to take help of a financial advisor before making such decisions.
What is the Historical Context of Watered Stock?
The term ‘watered stock’ originated in the 19th century when railroad companies were notorious for over-inflating the value of their stocks and assets. Just like a farmer would ‘water down’ their cattle to increase their selling weight, corporations were ‘watering down’ their stocks to increase perceived value.
How do Laws and Regulations Handle Watered Stock?
Various laws and regulations aim to prevent companies from issuing watered stock. Companies may face legal consequences if they knowingly issue overvalued shares that cannot be supported by assets, earnings, or potential for earnings.
Related Entrepreneurship Terms
- Overcapitalization
- Par Value
- Stock Dilution
- Asset Inflation
- Capital Surplus
Sources for More Information
- Investopedia: This website offers comprehensive information on all financial topics, including Watered Stock. It provides in-depth and easy-to-understand explanations.
- The Balance: The Balance is another great source of financial information. They provide insights into all financial terms and concepts.
- Marketplace: They provide a variety of financial news and information, and often discuss different financial terms and concepts such as watered stock.
- Nasdaq: This is the official site of the NASDAQ exchange, where they provide deep insights into many financial terms and definitions, including Watered Stock.
