You can teach math to a horse but the horse will never be a mathematician. Similarly accountants teach us, readers of financial statements, that treasury stock is equity. But I argue that treasury stock is an asset.
Generally Accepted Accounting Principles (GAAP) says that "assets are probable future economic benefits obtained or controlled by a specific company as result of past transactions or events."
An asset has three characteristics: (1) it is likely to contribute directly or indirectly to future net cash flows, (2) the company can obtain and control others' access to it and (3) the transaction has already occurred.
When a company buys its own stock management is signaling to investors that the stock is undervalued. Also, when a company buys back its shares, each investor's ownership interest increases. So stock buybacks are valuable and meet the three characteristics of an asset.
Look for a second opinion, especially when considering big changes to your portfolio or strategy. Unbiased, professional insights can help you reexamine your assumptions and reduce emotional decisions.
Join the waitlist to learn more.
Yet the accounting is goofy. Consider International Business Machines (IBM on Nyse). Over the past decade, IBM's balance sheet showed deficits in the equity balance. In 2018 the loss in equity balance was $25 per share. And yet during this 10-year period, IBM was profitable (the 10-year average earnings per share is over $5). That a negative equity balance can produce profits is an accounting distortion.
The accounting distortion is the result of IBM's share repurchase program. In 2009 IBM had 1.3 billion outstanding common shares while management reported on 892 million outstanding shares as of the latest public filing, a compound annual decline of about 4% per year.
Another example is Signet Jewelers (SIG on Nyse) which I bought a few weeks ago. In 2019 SIG's management deducted from the equity balance $1,027 million because it bought 18.1 million shares. But just as the company bought the stock, management can sell the stock to the public. In SIG's case, using today's stock market, I estimated that management can easily sell the common stock at $15 per share (a 25% discount to current price) for total proceeds of $271 million or $5 per share.
I asked a friend of mine who is an accountant why treasury stock is part of the equity balance and not reported as part of the assets. She explained that if treasury stock would have been reported as an asset, the accounting would get goofier. For one, she explained, a potential buyer of a company would not consider treasury stock valuable. The buyer would remove treasury stock to arrive at a fair value. So from the buyer's perspective the classification change would not be helpful.
Another reason why reporting treasury stock as an asset does not work in practice is related to the price of the stock. If company ABC’s management buys the stock at $10, and a year after the price of the stock drops to $5, under GAAP rules, company ABC would report an impairment loss, directly affecting the income statement.
This would be a double-edged sword. Just as the company operations would deteriorate (the probable reason why the stock fell in price) the company would take a further loss to the income statement.
Students of financial history will remember that prior to 1982, stock repurchases were illegal. Buyback activity, which is expected to be greater than $800 billion in 2019, was considered a stock market manipulation according to Forbes.
This activity continues to be unfavored by some. For example Senators Chuck Schumer and Bernie Sanders proposed to limit corporate stock buybacks in a New York Times Op-Ed. Their main arguments were that stock buybacks hurt the economy because indirectly they discourage investment and innovation.
Like many things in life, an action, in itself, is neither good nor bad. It just depends. It is bad action when management buys back the stock when the shares are overvalued (say, trading at above 30 times the trailing earnings per share).
It is good action when the inverse happens - when management buys back the stock at undervalued prices or if buying back the stock is the best available option.
Binary thinking just does not work in investing. Treasury stock is, at times, an asset; sometimes it’s part of the equity balance; and sometimes it's both. This similar to the Jewish tale:
Two neighbors were fighting over a financial dispute. They couldn’t reach an agreement, so they took their case to the local rabbi. The rabbi heard the first litigant’s case, nodded his head and said, “You’re right.”
The second litigant then stated his case. The rabbi heard him out, nodded again and said, “You’re also right.”
The rabbi’s attendant, who had been standing by this whole time, was justifiably confused. “But, Rebbe,” he asked, “how can they both be right?”
The rav thought about this for a moment before responding, “You’re right, too!”