Share Repurchases and Reduced Equity
As you learned in The Benefits of Stock Buy Back Programs, share repurchases can make you substantially wealthier by reducing the total number of shares outstanding, increasing your equity ownership as a percentage of the total business. Your respective portion of the profit and dividends grows even if the underlying enterprise does not. When combined with healthy, cash-generating operating results, share repurchases can result in huge long-term rises in earnings per share, as evidenced by companies such as Coca-Cola and The Washington Post.Due to the peculiarities of Generally Accepted Accounting Principles (GAAP), however, wealth-creating buy back programs can actually cause a potential investment to appear riskier than it is in reality. The reason: When a company repurchases its shares, the result is a reduction in the stated value shareholders’ equity. To understand why this occurs, we’ll have to delve into the accounting entries that are recorded each time stock is issued.
Imagine Seattle Enterprises, a fictional company that operates a chain of retail stores, wants to raise $100,000 for a new facility by issuing 5,000 shares of common stock. The shares have a par value of $5 each and will be sold for $20. The accounting entry would appear as follows:
Cash Debit $100,000
Common Stock – Par Credit $25,000
Common Stock – In Excess of Par Credit $75,000
The corporation raises capital and the result is that the proceeds are allocated to two lines in the shareholders’ equity statement of the balance sheet; the first $25,000 consists of 5,000 shares issued multiplied by $5 par value per share; the remaining line results from multiplying the excess purchase price ($20 per share - $5 par value = $15 excess) by the number of shares issued ($15 x 5,000 shares = $75,000). The cash obviously ends up in the company coffers and must be debited to the appropriate account ($100,000).
Now, imagine a few years have past. Management wants to repurchase $50,000 worth of stock. The transaction is going look something like this:
Treasury Stock Debit $50,000
Cash Credit $50,000
Because the shareholders’ equity section normally has a credit balance, the Treasury Stock (a debit balance) serves to reduce the overall stated value. The result of this sad state of affairs is an increase in the debt-to-equity ratio. In fact, should the share repurchases grow large enough, it’s possible that a perfectly healthy, prosperous company could have a negative stated net worth and appear to be leveraged to the hilt!
“Couldn’t you argue that the cash has been spent and therefore the securities pose a higher risk because of the reduced asset base?” Yes, you could. If you own an excellent business that, by definition, generates tons of cash, however, this ordinarily need not be a concern. Your shares now receive a larger portion of the net income and dividends with no increase in the debt load.
