Treasury Stock Basics
Treasury stock is the shares of a company that have been repurchased by the company. The company can buy shares from the public stockholders or in the open market, and they can issue treasury stock that is not available for trading on the open market. Companies usually use treasury stock as a way to raise capital, which they can then use to invest in other areas of their businesses, pay off debt or even repurchase more treasury shares. In most cases, companies will only buy treasury stock if they have excess cash available.
When a company buys treasury stock, it is not listed on their balance sheet as an asset, but is instead listed as a contra equity account. This means that, from an accounting standpoint, the company is actually reducing the amount of equity available. As a result, the company’s total stockholders’ equity will drop by the amount that is acquired through treasury stock.
It is important for investors to understand how treasury stock works, since it can directly impact the value of their investments. For instance, when a company acquires treasury stock, the total number of outstanding shares is reduced, and the value of each remaining share increases when the company repurchases shares. This can create a situation in which investors benefit, since they now have a larger percentage of ownership in the company, and their overall return on investment can be higher.
Why Would a Company Buy Treasury Stock?
There are several reasons why a company would buy treasury stock. The primary reason is to increase stockholder value while reducing the company’s float, or the total number of shares available to be traded. This can increase the company’s market capitalization as well as enhance shareholder returns. Other times, a company may use treasury stock to defend their shares from hostile takeovers. By reducing their float and engaging in share repurchases, the company can obtain a larger number of voting shares, and thus can more easily defend their position in the marketplace.
Another common reason companies will buy back treasury stock is to increase earnings per share. Since fewer shares are outstanding, the company’s total earnings will be divided among fewer shares, thus resulting in higher earnings per share. This can be beneficial for both the current shareholders, as well as for potential investors, as it can cause the stock price to increase due to improved earnings figures.
Lastly, some companies may repurchase treasury stock in order to compensate employees and executives. By offering stock options and grants to their employees, they can help to motivate and reward them for their hard work. Stock options can also be used as tools to attract and retain top talent.
Risks Associated With Treasury Stock
While there are merit to repurchasing treasury stock, there are also some risks associated. One of the main risks is that the company may purchase too much treasury stock, which could decrease liquidity. This can be an issue for smaller companies, since their available cash flow may not be able to service the repurchased shares, and this could result in high debt levels.
Another risk associated with treasury stock pertains to the tax code. If a company repurchases stock, they will be liable for any capital gains taxes that are applicable. This could result in increased pressures on the company, and could have a negative impact on their bottom line, depending on the circumstances.
Lastly, investors need to consider the impact that treasury stock will have on their portfolios. While the repurchasing of stock can lead to an increase in the price per share, investors must also understand that the returns on their investments may not be as high as they had originally anticipated. As such, investors need to weigh the pros and cons carefully before deciding whether or not to invest in a company that is actively repurchasing shares.
How to Evaluate Treasury Stock
When evaluating a company’s decision to repurchase treasury stock, it is important for investors to look at both the short-term and long-term impacts that this decision could have. Short-term investments may result in investors obtaining gains as a result of the increase in the value of their shares, while long-term investments may result in larger returns, as the company may utilize the capital they raise by repurchasing shares to fund other activities that could increase the company’s profits.
Investors should also assess the current financial position of the company, and determine whether or not they have the cash flow to adequately support the repurchases they are proposing. Additionally, they should evaluate the company’s future prospects and whether or not the repurchases are likely to create additional value for shareholders.
It is also important for investors to take a look at the company’s management. While repurchasing shares can be beneficial to both the company and its shareholders, it is important for investors to determine whether or not the current management team is capable of utilizing the additional capital effectively. This may require investors to conduct additional research and be aware of the decisions that management has made in the past.
Conclusion
Ultimately, it is important for investors to understand why a company may choose to buy treasury stock. While repurchasing shares can lead to an increase in the value of the company’s shares, it is important for investors to understand the risks involved and evaluate the company’s current financial position, future prospects and management team when making their decision.
