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.
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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!”
This week, quite bored from hearing about the new CEO of Chipotle, I doodled a list of companies using their 2017 return on equity ratio as a ranking criteria. The return on equity of two companies stood out. First was Colgate-Palmolive, the company responsible for our teeth and body hygiene, had showed a net income of about $2 billion for 2017. More impressive though, Colgate generated its profit using a reported average book value of $130 million. This translates to a return on equity of 823%.
The second company was IBM, an American multinational technology company. As of December 2017, the company profited $5.75 billion on an average book value of $9.58 billion for that year. While not as conspicuous return on equity ratio as Colgate, IBM’s reported return on equity of 60% is remarkable. But is it real?
With the risk of oversimplification, I will remind the reader that the higher the return on equity ratio is, the more valuable the company. Here is why: say that earlier this year you bought a stock with a book value of $10 for $10 per share. In investing jargon, we would say that you had bought the stock of company ABC at par. Let us further assume that company ABC will earn a return on equity of 60% for the next five years. With the assumption that management will retain all earnings over the next five years, the book value per share will be $105 in 2023. And if the quoted market price remains at par the book value, your interest in the company will be worth $105.
Let us further assume that to you bought the stock of company XYZ at the same price. But company XYZ earned a 6% return on equity. In 2023, using all the same assumptions, the value of your stock in company XYZ will be only $13.38.
You can see how important the ratio is: a difference of 60% compared to a 6% return on equity, resulted in an eight times higher value.
Intrigued by Colgate’s outlandish return on equity ratio, I printed the 2017 Colgate-Palmolive annual report. Here is what I learned on page 68: The reported equity balance of $243 million consisted of a $20.18 billion deduction related to treasury stock (note: the deduction was in the billions, not millions).
Since management was purchasing the company's common stock in the market place over the past few years, the cost associated with the stock purchase was deducted from the equity balance. And the related line item was titled “Treasury Stock, At Cost.”
Let us delve further in the numbers. On page 87 of the annual report, management explained that it acquired 19,185,828 common stock in 2017. But certainly the average cost could not be $1,047 - which can be calculated as the cost of $20.1 billion divided by 19.18 million of common stock - since the stock traded as low as $69 and as high as $77 in 2017. So, to estimate the true average cost, I had to find how many shares the company had acquired to date, and for that, I turned to page 68, where management reported on the book value figures.
From here the math was simple: since management had issued 1,465,706,360 shares to date, and there are 874,701,118 shares outstanding, management had purchased 591,005,242 shares for a total cost of $20.1 billion or an average of $34 per share.
The reader will note that the basic rules of bookkeeping state that when a company purchases something - whether it is real estate, inventory, or in our case, common shares - that purchase is an asset by definition as it is expected to provide future income. And the economic truth behind the line item reported under the name "Treasury Stock, At Cost" is that it is a real asset, with not only a very real cost basis, but also with a very real market value.
I estimated the market value of the treasury stock to be at least $30 billion, after deducting future taxes on the capital gains. I then added that estimated market value of the treasury stock to the equity balance and calculated a paltry return on equity of about 6%.
(Note: throughout this article I calculated the return on equity using the year end profit in the nominator and the average equity balance in the denominator. Please write to me if you would like to understand better the logic behind the formula.)
“Manager and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation,” said the Oracle from Omaha. My goal in writing this article was not to offer the reader a better method or solution of how to account for treasury stock, nor to claim that management, through their accountants, is deliberately trying to fool us.
My intent was to illuminate how tricky accounting is. And to stress that it is the responsibility of the investor to understand the true economics of the business and not just to read what is being reported by the accountants.
Similar to most things in life, it is important to acquire knowledge. But it is more important what you do with that knowledge.