Treasury Stock Method

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Treasury Stock Method — Calculating Diluted EPS

Key takeaways

  • The treasury stock method estimates how many additional shares would be created if in-the-money options and warrants were exercised.
  • It assumes exercise proceeds are used to repurchase shares at the average market price, producing a net increase in shares.
  • The method is required under GAAP when calculating diluted earnings per share (EPS).
  • Out-of-the-money or anti-dilutive options are excluded from the diluted share count.

What the treasury stock method is

The treasury stock method determines the incremental shares to add to the basic share count for diluted EPS. It applies only to in-the-money options and warrants — those with an exercise price below the current (or average) market price. The method assumes holders exercise these instruments at the start of the period and the company uses the cash received to buy back shares at the average market price.

How to calculate incremental shares (step-by-step)

  1. Identify the number of in-the-money options/warrants outstanding.
  2. Multiply that number by the average exercise price to get total proceeds from exercise.
  3. Divide the total proceeds by the average market price to estimate shares repurchased.
  4. Subtract repurchased shares from the assumed issued shares to get incremental shares:
    Incremental shares = Options outstanding − (Options outstanding × Exercise price / Average market price)
  5. Add incremental shares to basic shares to obtain diluted shares.
  6. Compute diluted EPS:
    Diluted EPS = Net income / Diluted shares

Example

  • Basic shares outstanding: 100,000
  • Net income: $500,000
  • In-the-money options outstanding: 10,000
  • Average exercise price: $50
  • Average market price: $100

Steps:
1. Proceeds from exercise = 10,000 × $50 = $500,000
2. Shares repurchased = $500,000 ÷ $100 = 5,000
3. Incremental shares = 10,000 − 5,000 = 5,000
4. Diluted shares = 100,000 + 5,000 = 105,000
5. Diluted EPS = $500,000 ÷ 105,000 ≈ $4.76

Important considerations

  • Exclude out-of-the-money or anti-dilutive options (those that would increase EPS) from the diluted calculation.
  • Use the period’s average market price where required by accounting rules to reflect typical trading conditions.
  • The method assumes cash settlement of exercises; cash-settled or share-based payment arrangements may be treated differently under accounting standards.
  • Other complex instruments (convertibles, contingently issuable shares) follow their own dilution rules.

Why it matters

The treasury stock method provides a standardized way to estimate the effect of option- and warrant-based dilution on EPS. It helps investors and analysts compare earnings performance on a per-share basis after accounting for potential increases in share count.