28/03/2023, 19:46 Treasury Stock Method: Definition, Formula, Example
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FUNDAMENTAL ANALYSIS TOOLS
Treasury Stock Method: Definition,
Formula, Example
By ANDREW BLOOMENTHAL Updated May 29, 2021
Reviewed by GORDON SCOTT
What Is the Treasury Stock Method?
The treasury stock method is an approach companies use to compute the
number of new shares that may potentially be created by unexercised in-the-
money warrants and options, where the exercise price is less than the current
share price. Additional shares obtained through the treasury stock method
factor into the calculation of the diluted earnings per share (EPS). This method
assumes that the proceeds a company receives from an in-the-money option
exercise are used towards repurchasing common shares in the market.
KEY TAKEAWAYS
The treasury stock method computes the number of new shares that
may potentially be created by unexercised in-the-money warrants and
options.
This method assumes that the proceeds a company receives from an
in-the-money option exercise are used to repurchase common shares
in the market.
The treasury stock method must be used by a company when
calculating its diluted earnings per share (EPS).
Understanding the Treasury Stock Method
The treasury stock method states that the basic share count used in calculating
a company's earnings per share (EPS) must be increased as a result of
outstanding in-the-money options and warrants, which entitle their holders to
purchase common shares at an exercise price that's below the current market
price. To comply with generally accepted accounting principles (GAAP), the
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28/03/2023, 19:46 Treasury Stock Method: Definition, Formula, Example
treasury stock method must be used by a company when computing its diluted
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EPS.
This method assumes that options and warrants are exercised at the beginning
of the reporting period, and a company uses exercise proceeds to purchase
common shares at the average market price during that period. The number of
additional shares that must be added back to the basic share count is
calculated as the difference between the assumed share count from the options
and warrants exercise and the share count that could have been purchased on
the open market.
Example of Treasury Stock Method
Consider a company that reports 100,000 basic shares outstanding, $500,000 in
net income for the past year, and 10,000 in-the-money options and warrants,
with an average exercise price of $50. Let's assume that the average market
price for the shares in the last year was $100. Using the basic share count of the
100,000 common shares, the company's basic EPS is $5 calculated as the net
income of $500,000 divided by 100,000 shares. But this number ignores the fact
that 10,000 shares can be immediately issued if the in-the-money options and
warrants are exercised.
Applying the treasury stock method, the company would receive $500,000 in
exercise proceeds (calculated as 10,000 options and warrants times the average
exercise price of $50), which it may use to repurchase 5,000 common shares on
the open market at the average stock price of $100.
The additional 5,000 shares (the difference between 10,000 assumed issued
shares, and 5,000 assumed repurchased shares) represent the net newly-issued
shares resulting from the potential options and warrants exercise.
The diluted share count is 105,000 = 100,000 basic shares + 5,000 additional
shares. The diluted EPS is then equal to $4.76 = $500,000 net income ÷ 105,000
diluted shares.
Important: The number of additional shares that must be added
back to the basic share count is calculated as the difference between
the assumed share count from the options and warrants exercise and
the share count that could have been purchased on the open market.
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28/03/2023, 19:46 Treasury Stock Method: Definition, Formula, Example
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Related Terms
What Is Diluted EPS? Definition, Formula, and Example
Diluted EPS is a performance metric used to assess a company's earnings per share if all
convertible securities were exercised. more
Earnings Per Share (EPS): What It Means and How to
Calculate It
Earnings per share (EPS) is the portion of a company's profit allocated to each
outstanding share of common stock, serving as a profitability indicator. more
What Are Stock Options? Parameters and Trading, With
Examples
A stock option gives an investor the right, but not the obligation, to buy or sell a stock at
an agreed-upon price and date. Learn more about how they work. more
If-Converted Method
Investors use the if-converted method to calculate the value of convertible securities if
they were converted into new shares. It also compares EPS to diluted EPS. more
Primary Earnings Per Share (EPS)
Primary Earnings Per Share is a measure of how much profit a company has generated
before including the effects of convertible security dilution. more
What Is Broad-Based Weighted Average? How It Works and
Example
The broad-based weighted average is an anti-dilution provision that can protect the
ownership of early preferred shareholders in a company. more
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