When a publicly traded company earns a profit, its profits are shared by investors who own company stock. Some companies distribute earnings directly to investors in the form of cash dividend payments. Some companies use part of their earnings to buy back shares of their own stock. Investors usually benefit through higher share prices when a company purchases its own stock even though share buybacks actually reduce total shareholders' equity.
Treasury Stock Versus Outstanding Stock
When a company files for incorporation with the government, the government approves a certain number of stocks it can sell to the public. Treasury stock represents the stock shares the company is approved to sell, but which are not owned by stockholders. For example, a company may be approved to sell 100,000 shares of stock. If it sells 50,000 shares to investors, it will have 50,000 shares of treasury stock and 50,000 shares of stock outstanding.
When a company buys back its own shares, it decreases the number of shares outstanding, while simultaneously increasing the amount of treasury stock it owns. Each share of outstanding stock represents a percentage of ownership in the company. Share buybacks increase the ownership percentage each remaining share of outstanding stock represents. However, stockholders' equity is actually simultaneously reduced. To understand this, you must first understand what stockholders' equity is.
Stockholders' equity is similar to equity represented by your home. Homeowner's equity represents the difference between the amount you owe your loan company and the amount you can sell your house for on the market. Likewise, stockholders' equity is the value of the company owned by shareholders after all company liabilities have been subtracted from company assets.
Share Buyback Effect on Stockholders' Equity
You can find a company's stockholders' equity on its balance sheet. To arrive at total stockholders' equity, company accountants add the value of all outstanding stock shares to retained earnings and then subtract the cost of its treasury share acquisition for the quarter, if any. When a company acquires new treasury shares through a buyback, it spends some of its cash. Cash is an asset, which is a component of stockholders' equity. Thus, an increase in treasury shares actually reduces total stockholder equity by the amount it cost the company to repurchase the shares for the quarter.