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Treasury Stock Method

Updated on May 8, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Treasury Stock Method?

The Treasury Stock Method assumes that the options and stock warrants are exercised at the beginning of the year (or date of issue if later). The proceeds from the exercise of options and warrants are used to purchase common stock for the treasury.

Key Takeaways

  • The Treasury Stock Method implements the exercise of options and warrants at the beginning of the year, using the proceeds to acquire common stock in the Treasury.
  • The net income in the numerator remains constant. Upon exercising options or stock warrants, the corporation acquires shares at the exercise price, adding to the total outstanding shares after repurchase.
  • Dilution arises when the option or warrant exercise price surpasses the stock’s market value. This results in a reduction in common shares and an anti-dilutive impact.

Explanation

  •  There is no adjustment to the net income in the numerator.
  • Upon exercising the options or warrants, the company receives the following amount of proceeds: exercise price of the option x number of shares issued to holders of the options or stock warrants.
  • The company will then use the proceeds from the exercise of options and warrants to buy back common shares at the average market price for the year.
  •  The net change in the number of shares outstanding is the number of shares issued to holders of the options or warrants less the number of shares acquired from the market.

Below are the three primary steps used for Treasury Stock Method

Treasury Stock Method

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Treasury Stock method formula for Net Increase in number of shares

Stock Options - Net Effect

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  • If the exercise price of the option or warrants is lower than the stock’s market price, dilution occurs.
  • If higher, the number of common shares is reduced, and the anti-dilutive effect occurs. In the latter case, exercise is not assumed.

Video Explanation of Treasury Stock

 

Treasury Stock Method Example

During 2006, KK Enterprise reported a net income of $250,000 and had 100,000 shares of common stock. During 2006, KK Enterprise issued 1,000 shares of 10%, par $100 preferred stock outstanding. In addition, the company has 10,000 options with a strike price (X) of $2 and the current market price (CMP) of $2.5. Calculated the diluted EPS.

Assume tax rate – 40%

Basic EPS Example
Effect of Stock Options on Basic EPS
Diluted EPS

Denominator = 100,000 (basic shares) + 10,000 (in the money options) – 8,000 (buyback) = 102,000 shares

Effect of Stock Options on Diluted EPS

Examples

Let us look at how Colgate has accounted for such Stock Options while calculating the diluted EPS.

Colgate Treasury Stock method v1

Source – Colgate SEC Filings

As you can see from above, for the year ended 2014, only 9.2 million were considered (instead of 24.946 million). Why?

The difference is 24.946 million – 9.2 million  = 15.746 million shares.

The answer lies in Colgate 10K – it mentions that diluted Earnings per common share are calculated using the “treasury stock method. We may assume that 15.746 may be related to the buyback using the Option Proceeds.

What next?

If you learned something new or enjoyed the post, please comment below. Let me know what you think. Many thanks, and take care. Happy Learning!

Frequently Asked Questions (FAQs)

1. What are the alternatives to the Treasury Stock Method?

Alternative methods to the Treasury Stock Method for calculating diluted earnings per share (EPS) include the “if-converted” method and the “two-class method.” The “if-converted” method assumes the conversion of convertible securities at the beginning of the period. In contrast, the “two-class method” treats certain securities as if they have rights to dividends, impacting the EPS calculation.

2. What is the benefit of the Treasury Stock Method?

The Treasury Stock Method is valuable for calculating the impact of potentially dilutive securities on diluted EPS. It considers the proceeds that the company could receive from the exercise of stock options or warrants and adjusts the diluted share count accordingly, offering a comprehensive view of the potential EPS impact.

3. What are the limitations of the Treasury Stock Method?

The Treasury Stock Method assumes that the company will use the proceeds from exercising options or warrants to repurchase its own shares at the current market price. This assumption might not always hold true in real-world scenarios. Additionally, the method does not consider the effect of anti-dilutive securities, leading to potential overestimation of the diluted EPS impact.

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Comments

  1. megha says

    its always a good piece of information shared by you, and so well explained..keep going best wishes

    • Dheeraj Vaidya says

      thanks Megha!

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