Treasury shares

What Are Treasury Shares?

Treasury shares, also known as treasury stock, are portions of a company's own common stock that it has repurchased from the open market. These shares were once issued and outstanding but are no longer held by public shareholders. Instead, they are held by the issuing company itself. Treasury shares are a component of corporate finance, representing a reduction in the number of shares actively trading in the market. While they remain issued, treasury shares are not considered outstanding for accounting purposes and do not carry voting rights or receive dividends. Companies typically engage in a share buyback program to acquire these shares.

History and Origin

For much of the 20th century, corporate share repurchases were viewed with skepticism and were often considered a form of market manipulation. However, a significant shift occurred in the United States in 1982 when the Securities and Exchange Commission (SEC) adopted Rule 10b-18. This rule provided a "safe harbor" from liability for manipulation under certain conditions, effectively legitimizing and streamlining the process of companies repurchasing their own shares⁹. The adoption of Rule 10b-18 marked a turning point, making share buybacks a widely accepted and increasingly common practice for capital distribution. Since then, the volume of corporate share repurchases has grown substantially, becoming a dominant form of returning capital to investors, often even surpassing dividends in aggregate value⁸.

Key Takeaways

• Treasury shares are a company's own stock that has been repurchased and held by the company.
• They are issued but not considered outstanding, meaning they do not have voting rights or receive dividends.
• Companies acquire treasury shares through share buyback programs for various reasons, including enhancing earnings per share (EPS) and increasing shareholder value.
• The reacquisition of shares impacts a company's capital structure and financial metrics.
• Treasury shares can be reissued later, used for employee stock options, or retired permanently.

Interpreting Treasury Shares

The existence of treasury shares on a company's balance sheet indicates that the company has actively managed its share count. An increase in treasury shares typically signals a belief by management that the company's stock is undervalued, or that it has excess cash that can be efficiently returned to investors. By reducing the number of outstanding shares, treasury share programs can boost per-share metrics such as earnings per share (EPS) and book value, even if net income remains constant. This can make the company's stock appear more attractive to investors. Conversely, a large number of treasury shares might also be interpreted as a company lacking sufficient internal investment opportunities, leading it to return capital to shareholders rather than reinvesting in growth.

Hypothetical Example

Imagine Company A has 1,000,000 shares of common stock outstanding. The company decides to initiate a share buyback program, repurchasing 100,000 shares from the open market. After the repurchase, these 100,000 shares become treasury shares.

Before the buyback:

• Issued Shares: 1,000,000
• Outstanding Shares: 1,000,000
• Treasury Shares: 0

After the buyback:

• Issued Shares: 1,000,000
• Outstanding Shares: 900,000 (1,000,000 - 100,000)
• Treasury Shares: 100,000

If Company A had a net income of $1,000,000 before the buyback, its EPS would be $1.00 ($1,000,000 / 1,000,000 shares). After the buyback, assuming net income remains the same, the EPS would increase to approximately $1.11 ($1,000,000 / 900,000 shares). This demonstrates how repurchasing shares and holding them as treasury shares can enhance per-share metrics.

Practical Applications

Treasury shares play several roles in corporate financial management:

• Capital Allocation: Companies use share buybacks to return excess cash to shareholders when they believe it's a more efficient use of funds than other investment opportunities or paying a dividend.
• Enhancing Shareholder Value: By reducing the number of outstanding shares, treasury share programs can increase earnings per share (EPS) and potentially the stock's market price, thereby increasing market capitalization. This can make the remaining shares more valuable to existing shareholders.
• Offsetting Dilution: Companies often issue new shares as part of employee compensation plans, such as through stock options. Holding treasury shares allows a company to reissue these shares to employees without causing further dilution to existing shareholders.
• Flexibility for Future Needs: Treasury shares provide a company with the flexibility to reissue stock quickly for mergers and acquisitions, future capital needs, or other strategic purposes without going through the process of issuing new shares.
• Defensive Measures: In some cases, repurchasing shares can be a defensive tactic to prevent hostile takeovers by reducing the number of shares available on the open market and making the company more expensive to acquire.
• Signaling: A company's decision to repurchase its own stock can signal to the market that management believes the stock is undervalued, potentially instilling greater investor confidence⁷. The volume of such buybacks has significantly increased over the past two decades⁶.

Limitations and Criticisms

While beneficial, the practice of holding treasury shares and conducting share buybacks faces several criticisms and limitations:

• Short-Term Focus: Critics argue that share buybacks can prioritize short-term boosts to earnings per share over long-term investments in research and development, capital expenditures, or employee wages⁵. This focus might deplete a company's liquidity and hinder sustainable growth⁴.
• Executive Compensation: There are concerns that buybacks may be used to inflate stock prices, thereby benefiting executives whose compensation is tied to stock performance or stock options³. This could potentially create a misalignment of incentives between management and long-term company health.
• Market Manipulation Concerns: Despite the "safe harbor" provided by SEC Rule 10b-18, some argue that large-scale buybacks can still influence stock prices in ways that might resemble manipulation². However, academic research provides mixed evidence on these claims, with some studies suggesting that buybacks are primarily driven by residual cash flow after investment spending¹.
• Capital Misallocation: If a company repurchases shares at an inflated price, it can be a poor use of capital, essentially destroying shareholder value. The cash used for buybacks could otherwise be invested in the business, used to pay down debt, or distributed as dividends.
• Impact on Equity and Retained Earnings: When treasury shares are purchased, they reduce the company's equity on the balance sheet, specifically impacting retained earnings or additional paid-in capital, depending on the accounting method used.

Treasury Shares vs. Outstanding Shares

The primary distinction between treasury shares and outstanding shares lies in their ownership and legal status.

While both are "issued" by the company, treasury shares are essentially dormant from an operational and shareholder rights perspective, whereas outstanding shares represent the active ownership base of the company. The decision to move shares from outstanding to treasury status is a key capital structure management strategy.

FAQs

Why do companies buy back their own shares to create treasury shares?

Companies buy back their own shares for several reasons, including to increase earnings per share, signal to the market that their stock is undervalued, return excess cash to investors, and offset the dilution from employee stock option programs.

Are treasury shares considered assets?

No, treasury shares are not considered assets. They are typically recorded as a contra-equity account on the balance sheet, reducing the total equity of the company. A company cannot own itself, so its own stock cannot be an asset.

Can treasury shares be reissued?

Yes, treasury shares can be reissued by the company. They can be sold back into the open market, used for employee compensation plans, or exchanged as part of mergers and acquisitions. Reissuing treasury shares increases the number of outstanding shares.

How do treasury shares affect a company's financial statements?

When a company repurchases its own shares to hold as treasury shares, it reduces the company's cash and shareholders' equity. This typically leads to a decrease in the number of outstanding shares, which can boost per-share metrics like earnings per share (EPS).