What is the Treasury Stock Method?
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 share (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 options 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.
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 treasury stock method must be used by a company when computing its diluted 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.
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)
n = shares from options or warrants that are exercised
K = Average exercise share price
P = Average share price for the period
When to Use the Treasury Stock Method
This is a required calculation for a publicly-held company, since all public entities must report their diluted earnings per share on the face of the income statement. The only exception is when a business has such a simple capital structure that the diluted earnings per share figure is the same as its basic earnings per share. A simple capital structure means that a business has only issued common stock; there are no preferred stock, options, or warrants outstanding.
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.