Many factors can affect the value of an asset. There are times when the price is more than their actual worth. There are various reasons why stocks become overvalued. For instance, the account may have an inflated value. When we say inflated value, we refer to an artificial or a one-time increase in the property value. It can also be because of massive stock issuance made possible by stock dividends or programs on employee stock options.
This was not a common situation today, but it was back in the late 19th century. Business and company owners would claim that their company is worth more than what they are to sell shares at a price more than the underlying asset book value. Hence, when we think about it, it is more like a scam or fraudulent activity. The owners get profit for lying, and investors lose money for trusting. Everything that we have mentioned is all about our main topic: watered stocks.
What are watered stocks?
Imagine this: ranchers plan to sell their cattle soon. So, before they go to the market, they would let them drink an excessive amount of water. Hence, when they put up the cattle on the market for sale, they would weigh much more than their actual body weight. Heavier cattle means the buyers get to pay the ranches more. This is no different from the scheme that fraudulent company owners do to lure in unfortunate investors. We can take this as the perfect logic to watered stocks. Thus we called the stocks as such.
In trading, watered stocks are those shares that their owners declare that they have great value by looking at the underlying assets. However, their share’s value is very far from reality. The good news is that these acts have not been used recently, and the last known incident was already from a decade ago. Big thanks go to stock issuance structures and regulations.
How did the frauds execute watered stocks?
They, themselves, would make a company contribution in return for the inflated stock par value. When we say par value, we refer to the nominal value of the bond, stock share, or anything indicated on the document writing. When they do this, an increase in the company value would be reflected on the balance sheet. That contribution hides the reality that they have lesser assets compared to the one they reported. Investors would most likely realize this when it is already too late.
What happened to victims of watered stocks?
The victims had a difficult time selling shares. Whenever they found buyers, they could only sell the shares lower than the original price. Here is more, the victims are liable for the difference between the company’s actual value and book value if the creditors foreclosed the company assets. For example, you paid $10,000 and did not know that stock is only worth $6,000. If the creditors foreclosed the assets, you are still liable for that $4,000 difference.
What stopped these fraudulent acts?
There are two reasons why these watered stocks finally came to an end. First, companies needed to issue shares either at a low or no par value. Most of the time, lawyers were alert to the chances of watered stocks that will become a disadvantage for investors. Second, investors became more vigilant. They also believed in the promise that the stock par value presented will be the actual value. Also, people made accounting guidelines about the difference between asset values and low or no par values. They need to be accounted for as additional paid-in capital or capital surplus.