Treasury Stock Method

A method for calculating the effect of outstanding stock options and warrants on diluted EPS

What is the treasury stock method?

The treasury stock method is a way for companies to compute the number of additional shares that can possibly be created by un-exercised, in-the-money warrants and stock options. These new additional shares can then be used in calculating the company’s diluted earnings per share (EPS). The treasury stock method implicitly assumes that the proceeds the company receives from in-the-money option exercises are then used to repurchase common shares in the market. Repurchasing those shares turns them into treasury stock, hence the name.

The treasury stock method implicitly assumes that the proceeds the company receives from in-the-money option exercises are then used to repurchase common shares in the market. Repurchasing those shares turns them into treasury stock, hence the name.

To comply with generally accepted accounting principles (GAAP) when reporting their financial statements, the treasury stock method must be used when computing the companies diluted EPS. EPS is diluted because of outstanding in-the-money options and warrants, which entitle their holders to purchase more common shares at an exercise price below the current market price.

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Implementing the treasury stock method

The treasury stock method has certain assumptions. Firstly, it assumes that the options and warrants are exercised at the beginning of the reporting period, and a company uses the exercise proceeds to purchase common shares at the average market price during the period. This is reflected in the treasury stock method formula.

Treasury stock method formula:

Additional shares outstanding = Shares from exercise – repurchased shares

Additional shares outstanding = n – (n x K / P)

Additional shares outstanding = n (1 – K/P)

 

Where;

N = shares from exercise

K = Strike price

P = Average share price for period

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Example

For example, a company has in-the-money options and warrants outstanding for a total of 15,000 shares. The exercise price of each of these options are $7. The average market price, however, for the reporting period is $10. Assuming all the options and warrants outstanding are exercised, the company will generate 15,000 x $7 = $105,000 in proceeds. Using these proceeds, the company can buy $105,000 / $10 = 10,500 shares at the average market price. Thus, the net increase in shares outstanding is 15,000 – 10,500 = 4,500.

This can also be found by simply using the last formula provided above. The net increase in shares outstanding is 15,000 (1 – 7/10) = 4,500.

Alternatively, use our free treasury stock method calculator to determine the effect on shares outstanding when stock options and warrants are exercised.

 

Treasury Stock Method

 

Effect on diluted EPS

The exercise of in-the-money options and warrants is the most dilutive of all potentially dilutive securities. As a summary, EPS is found by taking net income and dividing it by weighted average shares outstanding, or WASO.

Using the treasury stock method, there is no effect on net income, as all proceeds from the repurchase are assumed to be depleted in repurchasing treasury stock off the market. However, there is an effect on shares outstanding, or the WASO.

Since net income, the numerator, has a change of zero under the treasury stock method and the weighted average shares outstanding, the denominator, increases, there is a guaranteed decrease in the diluted EPS. This is why the treasury stock method is considered the most dilutive to EPS.

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