Treasury Stock Method Definition Formula Example
Contents
Treasury Stock Method: Definition, Formula, Example
Andrew Bloomenthal has over 20 years of editorial experience as a financial journalist and services marketing writer.
What Is the Treasury Stock Method?
The treasury stock method is a company’s approach to computing the potential number of new shares created by unexercised in-the-money warrants and options, where the exercise price is lower than the current share price. Additional shares obtained through this method factor into calculating diluted earnings per share (EPS). This method assumes that the proceeds from an in-the-money option exercise are used to repurchase common shares in the market.
Key Takeaways
- The treasury stock method computes the potential number of new shares created by unexercised in-the-money warrants and options.
- This method assumes that the proceeds from an in-the-money option exercise are used to repurchase common shares in the market.
- The treasury stock method must be used when calculating 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 due to outstanding in-the-money options and warrants, which allow holders to purchase common shares at an exercise price below the current market price. To comply with generally accepted accounting principles (GAAP), companies must use the treasury stock method when calculating diluted EPS.
This method assumes that options and warrants are exercised at the beginning of the reporting period, and the exercise proceeds are used to purchase common shares at the average market price during that period. The additional shares added back to the basic share count are 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 with 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 100,000, the company’s basic EPS is $5 calculated as the net income of $500,000 divided by 100,000 shares. However, 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 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 divided by 105,000 diluted shares.
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.
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.