Treasury Stock Method – Complete Beginner’s Guide!

What is Treasury Stock Method?

• Treasury Stock Method method assumes that the options and warrants are exercised at the beginning of the year (or date of issue if later) and the proceeds from the exercise of options and warrants are used to purchase common stock for the treasury.
• There is no adjustment to net income in the numerator.
• Upon exercise of 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 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 number of shares issued to holders of the options or warrants less the number of shares acquired from the market.

Below are the 3 primary steps used for Treasury Stock Method

Treasury Stock method formula for Net Increase in number of shares

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

Treasury Stock Method Example

During 2006, KK Enterprise reported 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 strike price (X) of $2 and the current market price (CMP) of $2.5. Computed the diluted EPS.

Assume tax rate – 40%

Basic EPS Example

Diluted EPS

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

Examples

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

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 is computed using the “treasury stock method. With this we may assume that 15.746 may be related to the buy back using the Option Proceeds.

Also, check out Restricted Stock Units vs Stock Options

Treasury Stock Method Video

What next?

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