Companies offer shares of stock to the general public when they want to raise capital. However, sometimes, it makes sense for them to repurchase some of their outstanding shares, which then become treasury stock.
In this article, we’ll explore what treasury stock is, why companies would want to repurchase their outstanding shares and their effect on a company’s financials.
When a company begins repurchasing stock shares to limit the number of shares outstanding, these are called treasury stock or reacquired shares. On paper, treasury stocks don’t have much value. They don’t provide dividends or have voting rights like common shares. They also don’t factor into earnings per share (EPS) calculations. However, repurchasing shares can immediately impact a company’s share price.
You might wonder what happens to treasury stock once it’s back on the company’s books. The company can either hold onto it so it can be reissued in the future or eliminate it altogether.
Why Would Companies Want to Repurchase Outstanding Shares?
So, what’s the point of public companies repurchasing outstanding shares of common stock? Companies can choose to limit the number of shares they have available for several reasons.
Boost Shareholder Value
A major goal for any publicly traded company is to return shareholder value. When companies repurchase shares, it almost immediately helps boost their stock price. Because fewer shares are available, each issued share will have a higher value.
Improve Market Sentiment
Going side-by-side with improving the stock price, repurchasing shares can also help with market sentiment. For example, if weak earnings or negative news have adversely affected a company’s stock price, but it’s gone further than its management thinks it should have, it could choose to repurchase shares. The goal is for Wall Street to see this move as a vote of confidence from executives that things have gone too far.
Also Read: What Does It Mean to Buy The Dip?
Prevent Hostile Takeovers
Repurchasing shares can also be a company strategy to avoid a hostile takeover. When fewer outstanding stock shares exist, it’s more difficult for activist investors to buy enough shares to hold significant voting rights.
Alternative Way To Reward Shareholders Beyond Dividends
While taxes on capital gains and dividends have become parallel over the past couple of decades, there was a large difference between the two until 2003. In 2003, President Bush’s tax cuts lowered the tax on dividends from the individual tax rate to a flat 15%. Before this, companies would buy back stock as an alternative to paying dividends to stockholders. Because of the high dividend tax, this would typically be better for investors.
Improve Financial Ratios for the Company
When a company does a stock repurchase, it either cancels the shares or transfers them to treasury stock. Regardless of its choice, this process reduces the number of outstanding shares.
This share reduction will increase return on equity (ROE) because there is less outstanding equity. It will also increase the return on assets (ROA) because the total assets are reduced. Plus, earnings per share (EPS) will increase because of the reduced number of shares available. Each of these things is viewed as a positive.
However, it’s also important to understand that share repurchases to improve financial ratios can be a bad sign for management and the company. However, if a valid reason exists to repurchase shares, the improved financials are just the icing on the cake.
Provide the Ability to Offer Stock Options to Talent
Many companies offer stock options to their most coveted employees. This can be a very lucrative way to retain talent, but it requires them to have the shares available. This can be done by periodically repurchasing available shares and having treasury stock on hand when they need to convert stock options.
How Companies Repurchase Outstanding Shares
Repurchasing outstanding shares can be done in a couple of different ways.
Open Market
Companies can choose to repurchase shares on the open market at their current market price. This is the most common way for companies to buy back shares.
Tender Offer
Some companies also repurchase shares by offering current shareholders a tender offer. This tends to be within a price range above the current market value.
How Does Treasury Stock Affect The Balance Sheet
When common shares are repurchased, it affects a company’s financial statements. Doing this adds treasury stock to their balance sheet. This can have a short-term negative effect because the cash used to make the repurchase will lower the company’s total assets.
But what happens if the company chooses not to retire the treasury stock and reissues it? If the price had increased when it was held as treasury stock, the company could sell it again at a profit. This would have a positive effect on their balance sheet because the proceeds would be credited to their balance sheet to the “Paid in Capital, Treasury Stock” account.
However, there are times when the company may need to sell the treasury stock shares even though the stock price has fallen. When this happens, the loss would appear on the balance sheet as a debit under the “Retained Earnings” account.
The Bottom Line
Treasury stock is shares of stock that a company decides to repurchase. This is often done to prevent hostile takeovers or boost the stock price. However, it’s important to understand why the company adds treasury stock to its balance sheet before investing.
Frequently Asked Questions
Why should shareholders pay attention to treasury stock?
Shareholders should always be aware when a company plans to buy back outstanding shares of stock because this can affect shareholders’ equity.
What is the difference between stock and treasury stock?
Company stock refers to the currently outstanding shares, whereas treasury stock refers to shares that are part of a stock buyback. Treasury stock can either be retired or held so that it can be offered again in the future.
Is treasury stock good or bad?
Treasury stock has no benefits since it doesn’t pay dividends or have voting rights. However, treasury stock can be a positive for a company because it can limit the number of outstanding shares available. This can help increase the stock price if company executives feel it’s below its worth. It can also help company executives keep control of their company.
Is treasury stock an asset or equity?
Treasury shares are not an asset. It’s a contra equity account and recorded on the shareholders equity section of a balance sheet.