A reader brought to my attention the fact that Aeropostale (NYSE:ARO) retired 47.5 million treasury shares in the third quarter, effectively wiping the slate clean and reducing retained earnings from $1 billion to $306 million. Shareholder equity didn't change, but the move will definitely throw you for a loop if you're not paying attention. You see, treasury shares wreak havoc on retained earnings.

Calculating Return on Retained Earnings
To calculate return on retained earnings, you need both the earnings per share growth for a particular period and the total EPS during this time. In addition, you need to confirm the total amount of dividends paid during this period. Using Aeropostale's latest five-year history, its earnings per share grew from $0.67 in 2005 to $2.27 in 2010. Since it paid no dividends, it earned an additional $1.60 in income from $6.44 in retained earnings producing a 24.8% return. Clearly, it's doing a good job with retained earnings.

Now I'll do the calculation using the five-year period from 2006-2011. Earnings per share will have grown $1.67 and the return on retained earnings is 20%. That's still good but is it accurate? With the retirement of shares, Aeropostale's retained earnings dropped by 70% and technically, while this is true, it's not real cash and shareholder equity isn't affected, so it's not a big deal.

What Retained Earnings Reduction Tells Us
If you look at Aeropostale's second and third-quarter balance sheets, you'll see that treasury stock went from a deficit of $699.7 million to a deficit of $1.8 million while retained earnings dropped $694 million as described in the opening paragraph. Essentially, they cancel each other out. It's why this happens that makes it interesting.

When a company retires stock, if it paid more for those shares than what it received when they were issued, the difference is deducted from retained earnings. If, on the other hand, they paid less, the difference is deducted from common stock and paid-in capital. In this example, we know that Aeropostale paid approximately $15.66 per share and, since retained earnings declined, we also know that it paid more for its shares than it received when it first issued them. That isn't unusual but wouldn't it be interesting to find companies that have repurchased shares below their issue price. That would be value investing at its core.

Why Keep Treasury Shares
When a company retires treasury shares, they become part of authorized shares or unissued shares and although they aren't destroyed, they can't be resold. Nonetheless, you have to wonder why companies keep treasury shares in the first place. Why not retire them immediately as Microsoft (Nasdaq:MSFT) does. In its first quarter report ended September 30, Microsoft had a $15 billion dollar retained earnings deficit. In a recent article, I was adamant that you couldn't have a good Z-Score if you didn't have positive retained earnings. Microsoft, however, is proof my statement isn't entirely correct. Despite a large deficit, Microsoft's Z-Score is 5.5, well above the acceptable minimum for healthy companies. This exception answers the above question. Most companies obviously feel it's simpler to separate shares repurchased from retained earnings and paid-in capital and the only way to do so is through the treasury shares account.

The Bottom Line
The top three S&P 500 stock buyback announcements in 2010 are Philip Morris (NYSE:PM), PepsiCo (NYSE:PEP) and Walmart (NYSE:WMT). Of these three, only Walmart immediately retires the shares it repurchases, bypassing the need for treasury shares. Although it doesn't have negative retained earnings, its latest quarter saw them decline despite making over $3 billion in net profit. If it were up to me, I'd make all companies do this. It might be slightly more complicated, but it simplifies shareholder equity. (A company's retained earnings matter. Be investment-savvy and learn how to analyze this often overlooked information. Check out Evaluating Retained Earnings: What Gets Kept Counts.)

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