What Is the Treasury Stock Method?
Let me explain the treasury stock method directly to you: it's the way companies figure out how many new shares could potentially come from unexercised in-the-money warrants and options, where the exercise price is below the current share price. These extra shares get included in the diluted earnings per share (EPS) calculation. The method assumes that the money from exercising those options goes right back into buying common shares from the market.
Key Takeaways
Here's what you need to grasp: the treasury stock method calculates the new shares that might arise from those unexercised in-the-money warrants and options. It presumes the proceeds from exercising in-the-money options are spent on repurchasing common shares in the market. And remember, companies have to use this method for their diluted EPS calculations.
Understanding the Treasury Stock Method
You should know that the treasury stock method requires increasing the basic share count for EPS due to outstanding in-the-money options and warrants, which let holders buy shares at a price lower than the market. To meet GAAP standards, companies must apply this when computing diluted EPS.
The assumption is that options and warrants get exercised at the start of the period, and the company uses those proceeds to buy back shares at the average market price. The additional shares added to the basic count are the difference between the shares from the exercise and those that could be bought back on the open market.
Example of Treasury Stock Method
Take this scenario: a company has 100,000 basic shares outstanding, $500,000 in net income last year, and 10,000 in-the-money options and warrants with an average exercise price of $50. The average market price was $100. Using just the 100,000 shares, basic EPS is $5, which is $500,000 divided by 100,000.
But we can't ignore that 10,000 shares could be issued if those options and warrants are exercised. With the treasury stock method, the company gets $500,000 from exercises (10,000 times $50), and uses it to buy back 5,000 shares at $100 each.
That leaves 5,000 net new shares (10,000 issued minus 5,000 repurchased). So the diluted share count is 105,000, and diluted EPS is $4.76, or $500,000 divided by 105,000.
Important
Keep this in mind: the additional shares added back are simply the difference between the assumed shares from exercising options and warrants and the shares that could be purchased on the open market with those proceeds.
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