Understanding the concept of treasury stock will help you make informed investment decision.
Offering shares to the public is basically a good way to raise capital for investment but there are times when a company may want to take charge of the number of shares circulating on the stock market.
Total number of shares owned by investors, including the company’s staff and insiders is known as outstanding shares.
What is Treasury Stock?
Treasury Stock, also known as treasury shares, is the portion of shares that a company keeps in its own treasury.
Treasury stock represents shares that were issued and traded in the open markets but are later re-purchased by the company to decrease the number of shares in circulation.
This means the total initially outstanding shares are no longer available to be traded in the markets as the number of outstanding share decreases.
For instance, given that a corporation has leftover cash and does not see any attractive investments to embark on. The company decides to buyback, say 15,000 shares of its outstanding 200,000 shares of common stock that is held by its stockholders.
The market value of the 15,000 shares is $20 per share. The corporation’s entry to record the purchase of these shares of stock is: Debit Treasury Stock for $300,000 and Credit Cash for $300,000.
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Thus, buying back of outstanding shares serves a number of purposes such as preventing unwanted corporate takeovers and providing alternative forms of employee compensation.
Treasury Stock Related Terms
Your understanding of the concept of treasury stock will not be lucid if you don’t know the following related terms.
This is the amount of stock the company can lawfully sell to public investors.
During the initial public offering, the company will normally put forward a fewer than the fully authorized number of shares on the auction block.
This is the shares the company actually sells. That’s because the company may want to have shares in reserve so it can raise additional capital in the future.
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.
It is clear that the number of issued shares and outstanding shares are often one and the same but if the company performs shares buyback then the shares marked as treasury stock are issued shares, no longer outstanding.
After Buyback Options
When a company decides to buy back shares, it has two options before it. Retire the shares or hold onto them for other uses.
But why would a company retire shares? Or why would a company hold onto shares after buyback?
You should know that reduction in total number of outstanding shares would mean reduction in the likelihood of paying additional dividends on the re-purchased or retired shares. And the company’s cash flow will also decline.
The reasons companies hold onto shares includes compensating employees, raising capital in the future, or using them for mergers and acquisitions.
In practice, the hold-onto-share option allows the company use the stock as part of an employee stock compensation plan to reward key employees.
Is Treasury Stock Different from Capital Stock?
Capital stock refers to the amount of shares that a company is authorized to issue to the public under its corporate charter.
Investors who are shareholders of a company’s capital stock will have various degrees of voting rights, dividend payments, and other benefits. The capital stock is included in the calculation of (EPS) and other metrics.
Treasury stock is capital stock that has been repurchased by the company and has been extracted from the public market and no longer eligible to be traded.
Treasury shares do not allow for voting rights or pay dividends. Therefore, they are not included in the calculation of (EPS) and other metrics.
Effects of Treasury Stock on Outstanding Shares and Value
Since the shares are no longer outstanding, there are four common effects:
- The repurchased shares are not included in the calculation of basic or diluted earnings per share (EPS).
- The repurchased shares are not included in the distribution of dividends to equity shareholders.
- The repurchased shares do not retain the voting rights previously given to the shareholder.
- An increase in treasury stock via a share buyback can cause the share price of a company to have a spurious increase.
Treasury Stock Justification
Treasury stock mechanism does not have direct influence on the individual investors. Shares buyback is often used to determine whether its share price is currently undervalued.
Theoretically, share buyback is a crucial program when company’s shares are underpriced by the market.
If the company’s share price has falls continuously the management could apply buyback because it can send out a positive signal to the market that the shares are potentially undervalued.
Companies use treasury stock use to shield themselves financially, plan for future mergers or acquisitions, control unwanted buyouts, reward employees, or plan for future capital raising needs, among other reasons.
Buyback will enable the company’s excess cash to be utilized to return some capital to equity shareholders rather than issuing a dividend.
What are the Importance of Treasury Stock
Corporations usually obtain treasury stock through a buyback of outstanding shares from current stockholders.
Buybacks can have a positive benefit on the market price of the corporation’s stock because they decrease the amount of equity on the market. A smaller number of outstanding shares suggest that the earnings per share will seem to increase when investors run the numbers.
Corporations that have excess cash can use this sort of device to advance the company’s overall financial position.
Treasury stock can also benefit a corporation by providing an incentive for use in employee stock option plans. Corporate stock has a higher upside potential than a cash bonus or a bump in salary because stock can appreciate significantly over time.
The unused shares sitting in the corporation’s treasury can fund a stock option plan without the corporation having to authorize extra shares. Stock that is sitting in the treasury is unavailable for purchase in the event of a hostile takeover moves.
This treasury stock can be reissued at any time by simply changing the ownership percentage that is required to control a vote to replace the board or management.
This stock is an asset that is banked for future use, benefiting the corporation by increasing its ability to control its financial position. One of the most basic beneficial uses of treasury stock is to return capital to shareholders in a way that minimizes their tax obligations.
A stock buyback is not a taxable project and the money used to buy back the stock is not taxed, but the shareholder is taxed only on money received after the stock is sold upon determination of capital gain.