Treasury stock is a broad term in finance and encompasses all kinds of stock purchased by the issuing company. Corporations buy back their shares for a variety of reasons. Such "buybacks" reduce the company's dividend expense and save money over the long run.
Treasury stock refers to all types of shares owned and held in the issuing company's treasury. Note that corporations can buy both their own shares as well as those of other companies. If, for example, IBM owns both its own shares as well those of Bank of America, only the IBM shares are considered treasury stock. The Bank of America shares are an investment and will be listed among other assets, such as gold, cash and so on, in the balance sheet. Shares bought by the issuing company are not counted among outstanding shares. If IBM has issued ten million shares and buys a million of them, the number of outstanding shares will only be nine million and treasury stock will amount to one million.
Treasury stock is not entitled to dividend payments. Since only shares owned by the issuing company itself are considered treasury stock, it does not make sense to pay dividends to these. Dividend payments to treasury stock would result in the company paying money to itself and would be a non-event. In fact, the primary reason companies buy their own stock is to reduce their dividend expense and save cash. As a result, the company will have more money to distribute to the remaining shares, thereby boosting dividends per outstanding stock.
Common Vs. Preferred Stock
Corporations have two basic share classes: common and preferred shares. Common shareholders can vote in the annual shareholder meeting to elect the board of directors, whereas preferred stockholders do not have voting rights. The board of directors determines the amount of dividend payable to common stockholders. The board determines this amount by considering the investment opportunities and other financial obligations and may therefore elect not to pay a dividend even if the company is profitable. Preferred shareholders, however, are entitled to a fixed annual cash payment that is contractually fixed. The board can suspend these payments in case of financial distress. However, until preferred shareholders are paid in full, common stockholders cannot receive any dividends.
When a company is considering purchasing its own stock, also called a buyback, it must weigh the large short term cash outlay against the gradual long term savings. Assume, the stock is trading at $10 per share and the company is paying $1 per stock in dividends. Buying a thousand shares will require spending $10,000 upfront. If the present dividend policy continues, this buyback will save the company $1,000 per year. Therefore the initial cash outlay will pay for itself in ten years. Firms will therefore buy back a large number of their own shares, only if they have excess cash reserves beyond their immediate investment needs.
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