Definition: Treasury stock can be explained as that chunk of stock which the company buybacks from its shareholders. The company had earlier issued these shares and these were available as the outstanding shares in the market for trading. These stocks are then used for reselling in future or retirement, as per the corporate need.
In simple words, treasury stock is that portion of corporate shares withdrawn by the company from the market by paying off its value to the shareholders.
Content: Treasury Stock
- Why do companies buy back shares?
- How do companies buy back shares?
- Method
- Implementation
- Assumptions
- Formula
- Example
- Pitfalls
- Conclusion
Why do companies buy back shares?
Treasury stock method can prove to be a turning point in the company’s strategic move if wisely implemented. Let us now unfold its multiple benefits:
- Undervaluation: At the time of market downturn, the company withdraws its stocks from the market with the intention of share value stability or avoiding its undervaluation.
- Enhancing Financial Ratios: When the company buybacks its stocks, there is an addition to its assets and decrease in liabilities, thus changing its financial ratios. Even the retired treasury shares bring about a change in the return ratios like ROE and ROA.
- Reselling: The company obtains such stocks to maintain a reserve which can be further used for compensating the investors, raising capital or at the time of mergers and acquisitions.
- Share Retirement: This is indeed another major reason behind stock buybacks. The company purchases its shares to eliminate it from the market which ultimately upraises the holdings of existing shareholders (in the form of higher dividends and increased profit share)
- Regulating Shareholders’ Interest: The public shareholdings can be controlled to a great extent by buying back a certain number of shares held by the stockholders.
- Decreases Cost of Capital: Most of the times, the company struggles to pay off dividends to the shareholders and therefore by repurchasing some of their shareholdings, it can cut down the cost of capital.
How do companies buy back shares?
The company can withdraw a portion of its stock from the market by using any of the following methods:
Open Market Operation or Direct Repurchase: The company can buy back its shares simply like the investors i.e., by directly purchasing it in the open market. Such a piece of news even raises the price of these stocks in the market.
Tender Offer: In this method, the company comes up with a buyback offer for a limited period where it is ready a higher or premium price for acquiring its stock. The shareholders are free to put up a tender for availing such benefits.
Dutch Auction: The company initiates a dutch auction where it mentions the number of shares and the price range at which it wants to buy back these stock. The shareholders quote their desired selling price (within the company specified price range). At last, the company closes the deal with the shareholders who quoted the lowest price and purchases the required number of shares.
Treasury Stock Method
TSM is a systematic approach of computing the additional shares which can be driven from the outstanding in-the-money options and warrants. Even in the formula for the diluted earnings per share (EPS) computation, the number of new additional shares play a key role.
Implementing the Treasury Stock Method
TSM is applied to determine the diluted earnings per share by the publicly-held companies. However, some companies are exceptions since they have a clear capital structure which equalizes their basic EPS and diluted EPS.
Assumptions of Treasury Stock Method
Following are the two basic assumptions taken into consideration while implementing the treasury stock method:
- The stock options and warrants are applicable at the initial stage of the reporting period.
- Also, the revenue generated by exercising options and warrants is spent at the time of reporting period, for buying the common stock priced at average market value.
Treasury Stock Method Formula
TSM determines the additional shares outstanding. The formula is:
where,
n is the number of exercised stock warrants and options;
K is the average exercise stock price;
P is the average stock price for the duration.
Example
QPR Ltd. has 22000 shares as total outstanding in-the-money warrants and options, while the per option exercise price is Rs.280. However, for the reporting period, the average stock market price is Rs.350. Determine the number of additional shares outstanding.
Solution
Additional Shares Outstanding=n(1-K/P)
n=22000
K=Rs.280
P=Rs.350
Additional Shares Outstanding=22000(1-280/350)
Additional Shares Outstanding=4400
Treasury Stock Pitfalls
When the treasury stocks are useful for fulfilling the corporate requirement, however, it is prone to certain shortcomings as discussed below:
- No Dividends: There is no count of the treasury stocks while the allocation of dividends on the share capital.
- Government Regulations: Different countries have varying norms for treasury stocks. Some nations limit the maximum percentage of capitalization which can be kept as treasury stocks.
- Timing Matters: Sometimes, the company ends up creating blunder by buying back its shares at peak time when the share value is high.
- No Rights on Net Assets: On liquidation, the treasury stock has no place in claiming the net assets of the company.
- No Preemptive Rights: The treasury stock doesn’t carry the right to acquire the common stocks of the company issued anytime in the future period, even before its allocation to the general public.
- Requires Capital: The company has to arrange for considerable funds for repurchasing its stocks that too at a higher price.
- Not Included in Outstanding Shares: In market capitalization, the treasury stocks are deducted from the publicly traded shares while calculating the number of outstanding shares.
Conclusion
When the risk of a hostile takeover is high, the company can resort to repurchasing its stock to retain its equity power. Even in the case of undervaluation, the companies use it as a strategy to upraise the price of shares.