When a business buys back its own shares, these shares become “treasury stock.” In and of itself, treasury stock doesn’t have much value. It doesn’t confer voting privileges or a claim to dividends. However, in certain situations, the organization may benefit from limiting outside ownership. Reacquiring stock also helps raise the share price, providing investors with an immediate reward.
Authorized, Issued And Outstanding Shares
To understand treasury stock, it’s important to understand a few related terms. When a business is first established, its charter will cite a specific number of authorized shares. This is the amount of stock the company can lawfully sell to investors.
When the organization undergoes a public stock offering, it will often put fewer than the fully authorized number of shares on the auction block. That’s because the company may want to have shares in reserve so it can raise additional capital down the road. The shares it actually sells are referred to as issued shares.
A company’s financial statements will sometimes reference yet another term – outstanding shares. This is the portion of stock currently held by all investors. The number of outstanding shares is used to calculate key metrics such as earnings per share.
The number of issued shares and outstanding shares are often one and the same. But if the company performs a buyback, the shares designated as treasury stock are issued, but no longer outstanding. And if management eventually decides to retire the treasury stock, the amount is no longer considered issued, either.
Why Buy Back Shares?
There are a number of reasons why a company will try to curtail its outstanding supply of stock, either through a tender offer to current shareholders -who can accept or reject the price that's put forward - or by purchasing shares piecemeal on the open market. The explanation that firms typically offer is that reducing the amount of stock in circulation boosts shareholder value. This makes sense. With fewer shares floating around, each share becomes worth more.
Take as an example Upbeat Musical Instruments Co., which trades in the market at $30 per share. The company currently has 10 million shares outstanding, but decides to buy back 4 million off them, which become treasury stock. The company’s annual earnings of $15 million aren’t affected by the transaction. So Upbeat’s earnings-per-share figure jumps from $1.50 to $2.50. Naturally, the remaining shares will command a proportionally higher price than its current market price.
Because a buyback boosts the share price, it’s an alternative to rewarding investors with a cash dividend. Previously, buybacks offered a clear tax advantage because dividends were taxed at the higher “ordinary income” level in the U.S. But in recent years, dividends and capital gains have been taxed at the same rate, all but eliminating this benefit.
Beyond making investors happy, corporations may have other motives for consolidating ownership. For example, with skilled executives in high demand, a company may offer stock options as a way to sweeten their compensation package. By accumulating treasury stock, they have a means to make good on these contracts down the road.
Buybacks also represent a defensive strategy for businesses that are targeted for a hostile takeover - that is, one that the management team is trying to avoid. With fewer shareholders, it becomes harder for buyers to acquire the amount of stock necessary to hold a majority ownership position.
If this is management’s goal, it can choose to keep the treasury stock on its books - perhaps hoping to sell it later at a higher price - or simply retire it.
Accounting For Treasury Stock
Though investors may benefit from a share price increase, adding treasury stock will - at least in the short-term - actually weaken the company’s balance sheet. To grasp why this is the case, consider the basic accounting equation: Assets - Liabilities = Stockholder’s Equity. The organization has to pay for its own stock with an asset (cash), thereby reducing its equity by an equivalent amount.
Issuance of Common Stock
Let’s take another look at Upbeat Musical Instruments. If the company originally sold 10 million shares for $35 each, the transaction would appear as follows. The amount it receives would be a debit to “Cash” and a credit to “Common Stock.”
Acquisition of Treasury Stock
Following the example above, let’s say the company decides to buy back 4 million of these shares at the current market price: $30 a share. The transaction will cost the Upbeat $120 million, which is credited to “cash.” It debits “Treasury Stock” – which appears under the “Stockholder’s Equity” section as a deduction – for the same amount.
Reissuance of Treasury Stock at a Profit
In many cases, a company will either hold on to this treasury stock for strategic purposes or decide to retire it. But imagine that Upbeat’s stock jumps up to $42 per share, and the company wants to sell it at a profit.
The proceeds of the transaction result in a $168 million debit to Cash (4 million shares bought back x $42/share). Because all the treasury stock is liquidated, the entire $120 million balance is credited back. The remaining $48 million represents a gain over its acquisition price. This amount is a $48 million credit to an account called “Paid in Capital - Treasury Stock.”
Because the account is depleted, Treasury Stock would still get a credit of $120 million. But, because of the lower stock price, the debit to cash is only $100 million. Retained Earnings is debited the remaining $20 million, reflecting the loss of Stockholder’s Equity.
The Bottom Line
Reducing the number of outstanding shares can serve a variety of important goals, from preventing unwanted corporate takeovers to providing alternate forms of employee compensation. For an active investor, it’s important to understand how the acquisition of treasury stock affects key financial figures and various line items on the balance sheet.
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