Treasury Stock Defined
| Treasury shares exist when a company buys back its own shares of stock without reissuing them or canceling them. |
When a company issues stock, net assets and stockholders equity increase because the company receives an asset, usually cash, in exchange for the stock. Similarly, when a company repurchases its own stock, net assets and stockholders equity decrease because the company used assets, generally cash, to repurchase the stock.
Treasury stock does not represent an asset to the company, but rather a reduction in stockholders equity. Cash or other assets are used to reduce stockholders equity by purchasing treasury stock. Treasury stock is stock taken off the market and not yet retired, thereby reducing the number of shares outstanding.
The amount of stock issued does not change, since the portion of the stock issued is now treasury stock. Since the stock has been purchased back by the company and is no longer outstanding, treasury stock does not confer voting rights, liquidation rights, or rights to dividends.
Why Companies Purchase Treasury Stock
State laws and federal agencies closely regulate transactions involving a company’s own capital stock, so the purchase of treasury shares must have a legitimate purpose. Some of the most common reasons for purchasing treasury shares are as follows:
1. To meet additional stock needs for various reasons, including newly implemented stock option plans, stock for convertible bonds or convertible preferred stock, or a stock dividend.
2. To eliminate the ownerships interests of a stockholder.
3. To increase the market price of the stock that returns capital to shareholders.
4. To potentially increase earnings per share of the stock by decreasing the shares outstanding on the same earnings.
5. To make more shares available for a merger.
Because the purchase of treasury shares reduces stockholders equity, a company can effectively increase its return on equity by purchasing its own stock.
When undergoing financial statement analysis, be sure to measure the return on equity with and without the effect of treasury stock.
To measure return on equity without the effect of treasury stock, add back the amount of treasury shares listed in the equity section of the balance sheet.
For example, with the purchase of treasury stock, Sunny Sunglasses Shop’s return on equity is 50.7%, and without treasury stock Sunny’s return on equity is 46.8%.
Below is a list of company’s that have purchased large amounts of treasury shares, with ROE calculations with and without the treasury shares:
Financial Statement Analysis: Adjusted ROE of Companies with Treasury Stock
| Company | ROE with Treasury Stock | ROE without Treasury Stock |
| Dell | 62.1% | 8% |
| IBM | 47.7% | 13.7% |
| Exxon | 38.5% | 18.2% |
| AT&T | 12.2% | 10.3% |
| Sunny Sunglasses Shop | 50.7% | 46.8% |
Most companies that purchase treasury shares tend to have large amounts of cash on hand to repurchase the stock.
Purchasing treasury shares often returns capital to shareholders without the tax burden of paying dividends. When a company repurchases stock, there are fewer shares outstanding on the same earnings. The stock price then may increase as earnings per share increase, increasing total stock earnings.
For example, if a company has 200,000 shares outstanding and earns $200,000 in net income, the stock earnings per share are $1 ($200,000/200,000). If the company purchases 25,000 shares of its own stock in treasury shares, then the earnings per share increases to $1.14 ($200,000/175,000). Some companies may also use stock repurchase programs to increase earnings per share to meet earnings estimates.
Treasury Stock vs. Cash Dividends
The advantage of repurchasing shares over dividends is that stock repurchases do not trigger a taxable event, while the payment of dividends is taxed at the time of payment. Stock buybacks, on the other hand, can be managed without a capital gains tax since the tax is deferred until the stock is sold.
Additionally, once a dividend is paid, investors expect that the company will continue to consistently pay dividends. Companies can use stock repurchase plans, on the other hand, at management’s discretion without creating the legal obligation of a dividend payment, or the expectancy of consistent dividend payments each year.
For these reasons, stock buybacks (retiring stock or holding them as treasury stock) has become a popular method of returning capital to shareholders. From 1997 through 2009, 438 companies in the Standard & Poor’s 500-stock index spent $2.4 trillion on stock repurchase programs.
When a company repurchases stock, there is no guarantee that shareholders will be rewarded with capital gains. In 2005, for example, Dell Computer spent upwards of $7 billion in cash to buy back shares priced in the mid 30s. By the end of the year, the price had fallen to the low 20′s and by 2009 to below $15.
Stock Repurchase Plans and Insider Selling
Stock repurchases are not in the shareholders interest when a company attempts to increase stock earnings per share and share prices so that company insiders’ own stock-based compensation is increased. Watch out for companies that repurchase stock while insiders simultaneously start selling stock or executives exercise stock options. Even when earnings are flat or declining, stock buybacks can artificially increase the per share price and stock earnings while company executives or other insiders exercise stock options or sell stock, thus grabbing a larger share of stagnant or even declining profits.
Treasury shares should not be based on enriching company insiders by funneling profits at the shareholder’s expense. Likewise, return on equity should be based on solid operational performance, and not on financial window dressing.
Advantages and Disadvantages of Purchasing Treasury Stock
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