Treasury stock explained: Why companies buy back their own shares

Why do companies buy back their own shares?

Companies buy back their own shares, turning them into treasury stock, for several strategic reasons. While reducing the number of shares available to investors may seem counterintuitive, this decision often aligns with a company's broader goals to improve shareholder value and strengthen its financial structure.

Here are the main reasons companies buy back their shares:

Boosting shareholder value

One of the main reasons companies repurchase shares is to increase the value of the remaining shares. By reducing the number of outstanding shares, each remaining share becomes more valuable, often leading to a higher stock price.

Improving financial metrics

Buying back shares can improve key financial metrics, particularly EPS, which is calculated by dividing net earnings by the number of outstanding shares. A lower number of outstanding shares can significantly boost EPS, making the company appear more profitable, even if overall earnings remain constant.

Signalling confidence

When a company repurchases its stock, the management signals to the market that the shares are undervalued. This often gives investors confidence that the company is in good financial health and expects future growth, which can positively impact the stock price.

Defensive strategy against takeovers

Share buybacks can also be used as a defensive tactic against hostile takeovers. By reducing the number of shares available on the open market, it becomes more difficult for an outside entity to gain control of the company.

Flexibility for future plans

Treasury stock can be reissued in the future for various purposes, such as employee stock option plans, acquisitions, or raising capital. Holding shares in reserve gives the company flexibility in managing its capital structure without having to issue new shares.

How is treasury stock used on a balance sheet?

When a company repurchases its own shares and designates them as treasury stock, those shares are reflected on the balance sheet under shareholders' equity, but with an important difference—they are recorded as a reduction in equity rather than an asset. This treatment aligns with the idea that treasury stock represents a withdrawal of capital from shareholders.

Treasury stock is considered a contra-equity account, meaning it reduces the overall equity value. For instance, when a company repurchases shares, the cost of those shares is debited from the treasury stock account, and the cash account is credited for the amount paid. This results in a lower total equity value on the balance sheet.

Treasury shares are not counted as part of outstanding shares and don't contribute to dividends, voting rights, or earnings per share (EPS) calculations.

There are two main methods to account for treasury stock:

• Cost method. This method records the shares at the repurchase price, regardless of their original issuance price. It is the most common approach used by companies. The treasury stock account is debited for the full repurchase cost, reducing total shareholders' equity.
• Par value method. This method values treasury stock at its par value (a nominal value assigned when shares are issued). Any difference between the par value and the repurchase price is adjusted through the additional paid-in capital (APIC) account.

Treasury stock example

To better understand how treasury stock works, let's look at a practical example:

Suppose a company called Brilliant Corporation initially issued 10 million shares to the public at a price of $50 per share. Over time, the company believes that its stock is undervalued and decides to repurchase 2 million shares at a price of $60 per share. These repurchased shares, now held as treasury stock, no longer count as outstanding shares.

That means they won't be included in the calculation of earnings per share (EPS) or dividends. Brilliant Corporation can hold onto these shares for future use, like reissuing them to employees as part of a stock option plan, or it may choose to retire them altogether, permanently reducing the number of shares in circulation.

On Brilliant's balance sheet, the treasury stock would be recorded as a reduction in shareholders' equity, reflecting the company's expenditure of $120 million (2 million shares x $60).

Treasury stock accounting may vary slightly depending on the method used to record the repurchase, either by the cost method or the par value method, but in both cases, the transaction reduces total equity.

Conclusion: Why treasury stock matters to investors

Treasury stock is used by companies to boost shareholder value and improve financial performance. When companies repurchase shares, they reduce the number of outstanding shares, which can drive up earnings per share (EPS) and increase stock value, making it an attractive strategy for those companies looking to reward investors.

For investors, understanding how and why companies use treasury stock can provide deeper insights into a company's overall financial health and growth strategy. It signals confidence from management and can protect the company against hostile takeovers, giving shareholders a clearer picture of its long-term potential.