Treasury Stock

The treasury stock method is an approach that companies use to compute the number of new shares that can potentially be created by unexercised in-the-money warrants and options. Additional shares obtained through the treasury stock method go into the calculation of the diluted earnings per share (EPS). This method assumes that the proceeds that a company receives from an in-the-money option exercise are used to repurchase common shares in the market.

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 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.

The 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 the period. The number of additional shares that must be 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.

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. 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. 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 can use to repurchase 5,000 common shares on the open market at the average stock price of $100.

The additional 5,000 shares, which is the difference between 10,000 assumed issued shares and 5,000 assumed repurchased shares, represent the net new shares issued as a result of 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.