Treasury stock is the type of equity shares that the issuing company stores in its own treasury, meaning the shares that the issuing company buys back from the investors. When a company buys back the stock, it reduces the number of shares outstanding in the open market.
So, treasury stock (also called treasury shares) is the shares that are issued but not outstanding. We do not use these shares to calculate the EPS (earnings per share) and dividends. A company can keep the treasury stock with itself for selling in the future. Also, a company can scrap or retire these shares. Such shares don’t carry a voting right.
- Authorized, Issued, and Outstanding Shares
- Key Features
- Why a Company goes for Buyback?
- How do Companies Buyback Stocks?
- Accounting Treatment
Authorized, Issued, and Outstanding Shares
To better understand the treasury stock, it is important to know some related terms.
Authorized capital is the total number of shares that the company can lawfully issue.
The number of shares that the company actually issues to the public is called issued shares of the total authorized capital. The company keeps the difference between the two in reserve for any future use.
Outstanding shares are also similar to the issued shares. But, the difference between the two gets evident when a company buys back the shares. The repurchased shares (or the treasury stock) remain issued but are no longer outstanding. If the company decides to retire the treasury stock, then it can’t re-issue these shares.
Now, let us understand the difference between treasury shares and retired shares. Unlike treasury shares, one cannot reissue retired shares. Once the company retires treasury stock, it can’t list or issue them again.
- Not entitled to dividends.
- Don’t enjoy any voting rights.
- Not included while calculating outstanding shares.
- No claim on net assets in the event of liquidation of the company.
- Some countries put a limit on the number of shares that can be shown as treasury stock.
Why a Company goes for Buyback?
A company uses treasury shares as a reserve by the company to pay for future purchases, like an asset or acquisition. Sometimes, the company also sells the shares to the existing shareholders as bonus shares.
To Get Controlling Interest
Buying back shares lowers the number of outstanding shares, thus, raising the value of shares with the existing shareholders, including the company itself.
Prevent Hostile Takeovers
The company also uses repurchase as a strategy to prevent other companies from acquiring it. Buyback lowers the total number of shares in the market, making it difficult for the hostile company to get a controlling stake.
Boost Share Price
A company also repurchases its shares when it believes they are undervalued. A buyback usually boosts the share prices and thus, benefits both – the company and the shareholders. A repurchase also gives a message that the issuing company is confident about its prospects.
A buyback is seen as an effective way to give cash to the shareholders than the dividends. Since a company carries buyback at above the market price, so shareholders have the incentive to make a profit. Also, it helps the company with taxes as well.
Improving Financial Ratios
Since buyback reduces the total number of shares in circulation, it improves several key financial ratios. Ratios like EPS (earnings per share) and PE (price-earnings ratio) automatically increase due to the buyback of shares. Moreover, as an after effect, a buyback decision also boosts the return on assets (ROA) ratio and return on equity (ROE) ratio.
How do Companies Buyback Stocks?
The company specifies the price at which it plans to repurchase the shares. The buyback price is set premium or above market price. The tender offer is for a limited time and invites interested investors willing to tender their shares.
Open Market or Direct Repurchase
Sometimes the company directly buys the shares from the open market. After the news of such a buyback, the share price usually rises.
In this, the company reveals the price range within which it will repurchase and the number of shares it plans to buy back. Companies then invite the investors to offer their shares within that range. The company chooses the price at which it will buy back the shares.
Treasury stock is similar to the unissued equity capital. Such shares are not assets; rather, they lower the ordinary share capital. Treasury shares are shown under equity capital as a negative number on the balance sheet.
Currently, treasury shares are shown at historical cost. However, there are ongoing debates that such shares must reflect the market value of the outstanding shares as a company can sell these shares in the open market or easily convert them into cash or productive assets.
Also, there are different rules regarding treasury shares in different countries. Like some don’t allow companies to carry these shares in the balance share. Instead, they want the company to retire these shares. Some limit the number of shares a company can convert to treasury stock.
Continue reading – Treasury Stock Vs. Common Stock.