What is Watered Stock?

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. For example, a stock promoter makes exaggerated claims about the future prospects of a company, convincing investors to buy up shares at an inflated price. This is a common tactic with penny stock pump and dump schemes. The seller of the shares then pockets the proceeds and leaves investors with valueless stock. The regulatory filings now imposed by the Securities and Exchange Commission make it much more difficult to engage in a watered stock scheme today.

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.

Characteristics of a Watered Stock Scheme

The key characteristics of a watered stock scheme are as follows:

Asset overvaluation. The company's assets are deliberately overvalued to inflate the stock price. Inflated valuations may be based on false appraisals, exaggerated revenues, or the inclusion of nonexistent assets.
Misrepresentation or false statements. Promoters or executives provide misleading information about the company's financial health, operations, or growth potential. These statements about the company's profitability or future prospects may be exaggerated or fabricated.
Manipulative practices. Insider trading or market manipulation techniques may be used to artificially drive up the stock price. This includes pump-and-dump schemes, where prices are inflated before insiders sell their shares, leaving others with worthless stock.
Collusion. Auditors, appraisers, or other third parties may collude with the perpetrators to validate the inflated valuations or provide credibility to the scheme.
Lack of due diligence. Investors may be discouraged from conducting independent due diligence or are provided limited access to authentic financial information.
Regulatory violations. The scheme often involves breaches of securities laws, including falsified financial disclosures and failure to comply with corporate governance standards.