What is the Treasury Stock Method?

Treasury stock method is used to compute the amount of new company shares or net increase in shares that can be created from outstanding in-the-money warrants or options. These increases (extra shares) are calculated by the diluted earnings per share (a method used to calculate how much a company earns for one unit of stocks, also known as EPS). The treasury stock method assumes that the returns which a company gets from an in-the-money warrant and option can be used for purchasing other market shares.

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How Does the Treasury Stock Method Work?

This method states that the share count involved in the calculation of an EPS should be increased due to unexercised in-the-money warrants and options. This is because holders of these in-the-money warrants and options are able to purchase shares at a price below the current market price. Each company is required to make use of the treasury stock method in calculating EPS to ensure compliance with generally accepted accounting principles (GAAP). The treasury stock method assumes that companies exercise warrants and options at the start of a reporting window and buy shares at the present market cost. Thus, it presumes that the basic share count should receive any additional amount of shares that is gotten from the difference of the initially assumed share count and the ones that had been bought at the beginning of the reporting window.

Illustration of Treasury Stock Method

Let us assume that a firm provides a report of 50,000 units of outstanding basic shares, a net income of $250,000 for the previous year, and 5000 in-the-money warrants and options, with a median price of $25. Let us also assume that the shares commanded an average price of $50 during the previous year. From the basic shares counts, we can see that this firms earning per share is $5 (net income divided by number of basic shares i.e., $250,000 divided by 50,000). However, we have not taken into account the presence of the firms 5,000 in-the-money warrants and options. Using this method, the firm has the opportunity of getting $125,000 in returns. This is calculated from the number of warrants and the cost of a basic stock, i.e. $25x5000. This amount can then be used to purchase 2500 shares as given by the price of a share in the previous year (i.e., $50 per unit). This additional 2,500 shares is the net increase in shares which can be gotten from outstanding in-the-money warrants. Thus, the total diluted share count can be calculated as 50,000 shares + 2500 extra shares = 52,500 shares, while the earning per shares will be given as $250,000 net income /52,500 shares = $4.76. 

Important Details to Note

• The treasury stock method helps in calculating the net increase in shares that can be gotten from outstanding in-the-money options and warrants.
• This method assumes that money gotten from these outstanding shares are used in purchasing new market shares
• Each firm is required to use this method when calculating their diluted earnings per share.