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When companies buy back their own shares, these reacquired shares are known as treasury stock. At first glance, it might seem counterintuitive—why would a company spend money to reduce the number of shares available to investors?
However, this strategy plays a crucial role in boosting shareholder value, stabilising stock prices, and even defending against potential takeovers.
In this guide, we'll explore the ins and outs of treasury stock: what it is, why companies pursue share buybacks, and how this decision affects financial statements and investors alike.
Treasury stock are shares that a company has repurchased from the open market or from shareholders. These shares were initially issued to the public but have since been reacquired by the company, and they are now held in the company's treasury.
Treasury stock differs from other shares because it is no longer considered outstanding, meaning: it doesn't grant voting rights, isn't entitled to dividends, and doesn't factor into earnings-per-share calculations.
Typically, companies buy back their own stock for strategic reasons that affect their financial structure. Treasury stock can also be held for future use, such as issuing shares for employee compensation or raising capital when needed.
Although treasury stock and common stock both represent shares in a company, they serve very different purposes and have distinct roles in a company's financial structure.
Common stock is what most investors typically hold. These shares are issued by the company to the public and provide shareholders with ownership in the company, voting rights on corporate matters, and eligibility to receive dividends.
Common stock is considered "outstanding" because it's actively traded in the market and affects financial calculations such as earnings per share (EPS) and dividends.
Treasury stock, on the other hand, represents shares that the company has repurchased from the public. Once reacquired, these shares are no longer outstanding, meaning they don't come with voting rights or dividend eligibility.
The company can hold treasury stock for future purposes, such as reissuing shares, or it can retire them to permanently reduce the number of shares in circulation. Unlike common stock, treasury stock is recorded as a reduction in shareholders' equity on the balance sheet.
In short, while common stock represents ownership and active participation in the company, treasury stock is a strategic tool companies use to manage their capital structure and shareholder value.
Companies buy back their own shares, turning them into treasury stock, for several strategic reasons. While reducing the number of shares available to investors may seem counterintuitive, this decision often aligns with a company's broader goals to improve shareholder value and strengthen its financial structure.
Here are the main reasons companies buy back their shares:
One of the main reasons companies repurchase shares is to increase the value of the remaining shares. By reducing the number of outstanding shares, each remaining share becomes more valuable, often leading to a higher stock price.
Buying back shares can improve key financial metrics, particularly EPS, which is calculated by dividing net earnings by the number of outstanding shares. A lower number of outstanding shares can significantly boost EPS, making the company appear more profitable, even if overall earnings remain constant.
When a company repurchases its stock, the management signals to the market that the shares are undervalued. This often gives investors confidence that the company is in good financial health and expects future growth, which can positively impact the stock price.
Share buybacks can also be used as a defensive tactic against hostile takeovers. By reducing the number of shares available on the open market, it becomes more difficult for an outside entity to gain control of the company.
Treasury stock can be reissued in the future for various purposes, such as employee stock option plans, acquisitions, or raising capital. Holding shares in reserve gives the company flexibility in managing its capital structure without having to issue new shares.
When a company repurchases its own shares and designates them as treasury stock, those shares are reflected on the balance sheet under shareholders' equity, but with an important difference—they are recorded as a reduction in equity rather than an asset. This treatment aligns with the idea that treasury stock represents a withdrawal of capital from shareholders.
Treasury stock is considered a contra-equity account, meaning it reduces the overall equity value. For instance, when a company repurchases shares, the cost of those shares is debited from the treasury stock account, and the cash account is credited for the amount paid. This results in a lower total equity value on the balance sheet.
Treasury shares are not counted as part of outstanding shares and don't contribute to dividends, voting rights, or earnings per share (EPS) calculations.
There are two main methods to account for treasury stock:
To better understand how treasury stock works, let's look at a practical example:
Suppose a company called Brilliant Corporation initially issued 10 million shares to the public at a price of $50 per share. Over time, the company believes that its stock is undervalued and decides to repurchase 2 million shares at a price of $60 per share. These repurchased shares, now held as treasury stock, no longer count as outstanding shares.
That means they won't be included in the calculation of earnings per share (EPS) or dividends. Brilliant Corporation can hold onto these shares for future use, like reissuing them to employees as part of a stock option plan, or it may choose to retire them altogether, permanently reducing the number of shares in circulation.
On Brilliant's balance sheet, the treasury stock would be recorded as a reduction in shareholders' equity, reflecting the company's expenditure of $120 million (2 million shares x $60).
Treasury stock accounting may vary slightly depending on the method used to record the repurchase, either by the cost method or the par value method, but in both cases, the transaction reduces total equity.
Treasury stock is used by companies to boost shareholder value and improve financial performance. When companies repurchase shares, they reduce the number of outstanding shares, which can drive up earnings per share (EPS) and increase stock value, making it an attractive strategy for those companies looking to reward investors.
For investors, understanding how and why companies use treasury stock can provide deeper insights into a company's overall financial health and growth strategy. It signals confidence from management and can protect the company against hostile takeovers, giving shareholders a clearer picture of its long-term potential.
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