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What is the Treasury Stock Method?

Treasury Stock Method

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Treasury Stock Method

The Treasury Stock Method is a way to estimate the potential dilution of a company’s earnings per share (EPS) if in-the-money stock options, warrants, restricted stock units (RSUs), or other convertible securities were exercised or converted into common stock. It’s used to help investors and analysts understand the potential impact on EPS from these dilutive securities.

Here’s how the Treasury Stock Method works:

  • Assumption of Exercise: Begin by assuming that all in-the-money options and warrants are exercised. This means options or warrants where the current stock price is above the exercise price.
  • Proceeds from Exercise: Calculate the proceeds the company would receive from this exercise. This includes the funds received from employees paying the exercise price of options and any tax benefits the company would receive from the option exercises.
  • Treasury Stock Purchased: Assume that the company uses all of the proceeds from the exercise to repurchase shares from the open market at the current market price. The idea is that the company is trying to offset the dilution by repurchasing its own shares.
  • Net Increase in Shares: The number of shares added from the exercise of the options or warrants minus the number of shares repurchased with the proceeds gives the net increase in shares outstanding.
  • Adjusted EPS: To get the diluted EPS, divide the net income by the new higher number of shares outstanding (original shares + net increase in shares).

A key thing to note is that the Treasury Stock Method only adds shares to the diluted EPS calculation when the current market price is higher than the exercise price of the options or warrants. This is because options or warrants are considered dilutive only when they are in-the-money.

Example of the Treasury Stock Method

Let’s delve into a detailed hypothetical scenario to illustrate the Treasury Stock Method.

Scenario:

Imagine a company named “GreenLeaf Corp.” with the following financial details:

  • Net Income: $2,000,000
  • Current Shares Outstanding: 1,000,000 shares
  • Average Exercise Price of In-the-Money Options: $15
  • Number of In-the-Money Options: 100,000
  • Current Market Price of the Stock: $25

Let’s calculate the diluted earnings per share (EPS) for GreenLeaf Corp. using the Treasury Stock Method.

Steps:

  1. Determine Proceeds from Exercise of Options:
    • 100,000 options x $15 exercise price = $1,500,000
  2. Determine the Number of Shares Repurchased Using the Proceeds:
    • Given the current market price of $25, GreenLeaf Corp. would be able to repurchase:
    • $1,500,000 / $25 per share = 60,000 shares
  3. Calculate Net Increase in Shares:
    • The number of shares added from exercising the options is 100,000. From this, subtract the 60,000 shares repurchased to get a net increase of:
    • 100,000 − 60,000 = 40,000 shares
  4. Calculate Total Shares for Diluted EPS:
    • Original shares outstanding (1,000,000) + Net increase in shares (40,000) = 1,040,000 shares
  5. Calculate Diluted EPS:
    • $2,000,000 net income / 1,040,000 shares = $1.92 per share

Conclusion:

In this example, GreenLeaf Corp.’s basic EPS (without considering the potential exercise of options) would be:

  • $2,000,000 / 1,000,000 shares = $2.00 per share

However, after considering the potential dilution from the exercise of options using the Treasury Stock Method, the diluted EPS is $1.92.

This demonstrates how the potential exercise of stock options can dilute earnings per share and why it’s essential for analysts and investors to consider both basic and diluted EPS when evaluating a company’s financial performance.

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