Watered stock is a deceptive practice often employed by dishonest business owners and entrepreneurs involved in fraudulent schemes to enrich themselves at the expense of unsuspecting investors. It involves issuing stock at a much higher price than the fair market value of the company, based on an inaccurate or inflated evaluation of its financial condition. By overstating the company's assets and understating liabilities, a dishonest business owner can make the value of the stock appear more attractive to potential investors.

The usual aim of watered stock is to take advantage of naïve investors, generate profits, and quickly make a quick exit before anyone realizes what has happened. Watered stock is also used to raise capital quickly without being subjected to the more stringent due diligence requirements imposed by established lenders such as banks.

The main risks of investing in watered stock depend on the particular scheme used and can have dire financial consequences for its buyers. There is no protection for investors against the fraudulent practices of the issuer, and the stock may be practically worthless upon revelation. Investors may find their money lost entirely, or at least suffer losses in their investment.

The most common ways that watered stock is produced include misstating the company’s book value, falsifying financial statements, or misrepresenting the company’s expected future earnings. Other schemes are also possible, such as creating fictitious assets or manipulating the return on assets results.

The Securities and Exchange Commission (SEC) strictly regulates securities to ensure fairness, full disclosure, and transparency of the markets. If a company is found to have issued watered stock, severe financial penalties, as well as criminal liabilities, may arise. Investors may also bring civil action against issuers that have been determined to have deceived them.

The prevention of watered stock is largely left up to the investor. It can be avoided by doing due diligence when researching potential investments and being skeptic of overly optimistic assessment of a company’s financial situation. Investors should always review the issuer's financial statements, projections, and marketing materials as well as seek independent, professional advice. Additionally, investors might choose to invest in publicly traded companies, which are typically subject to more stringent regulation and oversight by government authorities.