Treasury Stock Method: Calculating Diluted Earnings Per Share

The treasury stock method is a way for companies to calculate how many additional shares may be generated from outstanding in-the-money warrants and options. The new additional shares are then used in calculating the company’s diluted earnings per shareEarnings Per Share Formula (EPS)EPS is a financial ratio, which divides net earnings available to common shareholders by the average outstanding shares over a certain period of time. The EPS formula indicates a company’s ability to produce net profits for common shareholders. (EPS).

The treasury stock method implies that the money obtained by the company from the exercising of an in-the-money option is used for stock repurchases. Repurchasing those shares turns them into treasury stock, hence the name.

Generally Accepted Accounting Principles (GAAP) mandates that companies must provide details on their diluted EPS. Therefore, the GAAP method is utilized to compute this figure for financial reporting.

EPS is diluted due to outstanding in-the-money optionsStock OptionA stock option is a contract between two parties which gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period. A seller of the stock option is called an option writer, where the seller is paid a premium from the contract purchased by the stock option buyer. and warrants. These allow investors who own them to buy a number of common shares at a price below lower than the current market price.

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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 options or warrants that are exercised
• K = Average exercise share price
• P = Average share price for the period

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Implementing the Treasury Stock Method

The treasury stock method has certain assumptions:

1. The company repurchases common shares using an average price dictated by the market using the capital obtained when investors exercise their options
2. When exercising warrants and options, the exercise date assumed is the start of the reporting period.

Example

For example, a company has an outstanding total of in-the-money options and warrants for 15,000 shares. The exercise price of each of these options is $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 of this example on shares outstanding.

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Effect on Diluted EPS

The exercise of in-the-money options and warrants is the most dilutive of all potentially dilutive actions. 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 incomeNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through, 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.

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More Resources

We hope this has been a helpful guide to the treasury stock method of calculating diluted shares outstanding. If you’re interested in advancing your career in corporate finance, these CFI articles will help you on your way:

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