Treasury Stock Method – Complete Beginner’s Guide!

Employee Stock Options are complex call options granted by the companies as a part of the remuneration package. When stock options are exercised in large quantitites, it can have a significant impact on the total number of outstanding shares thereby diluting the EPS and negatively affecting the valuations of the firm.

To comply with GAAP, the dilutive impact of Stock Options and warrants must be captured using Treasury Stock Method . This article discusses the nuts and bolts of Treasury Stock method –

• What are Employee Stock Options
• How do Employee Stock Options affect Earnings Per Share?
• What is Treasury Stock Method?
• Treasury Stock Method Example
• Treasury Stock Method – Colgate Example

What are Employee Stock Options or ESO?

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Employee stock option  (ESO) is an “option” granted to the company employees that carries the right, but not the obligation, to buy promised number of shares at a pre-determined price. Please note that ESO are different from exchange traded options as they are not traded and don’t come with put component.

Also, please note that the pre-determined price is also called as a Strike Price or the Exercise price.

Have a look at this options table from Colgate’s 2014 10K. This table provides details of Colgate’s outstanding stock options along with its weighted average exercise price.

Source – Colgate SEC Filings

How do Employee Stock Options affect Earnings Per Share?

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• Stock Options can be excercised if the Market Price is greater than the Exercise Price or the strike price. (in-the-money)
• Once stock options are exercised, the company issues “shares” to the options holder.
• This in turn, increases the total number of outstanding shares 
• Earnings Per Share (Net Profit / number of shares outstanding) decreases as the denominator increases.

In addition, you should also be aware of two important Employee Option terminologies – Options Outstanding and Options Exercisable

• Options Outstanding is the total number of outstanding options issued by the Company, but not necessarily vested. These options may be in-the-money or out-of-money. In Colgate, Options outstanding are 42.902 million
• Options Exerciseable – Options that are vested as of now. These options again could be in-the-money or out-of-money. For Colgate, Options exerciseable are 24.946 million.

Let us take the example of Colgate 2014 10K, as noted above, there are 24.946 million employee stock options that are exerciseable. For considering the effect of dilution, we only take the “options exerciseable” and not the “Options outstanding”as many of the outstanding options may not have vested.

Let us compare the average exercise price of $46 with the current market price of Colgate. As of closing of June 13, 2016, Colgate was trading at $76.67. Since the Market Price is greater than the exercise price, all 24.946 million are in-the-money and therefore will increase the total number of shares outstanding will be 24.946.

Basic EPS

 

of Colgate

• Net Income 2014 of Colgate = 2,180 million
• Basic Shares = 915.1 million
• formula of Basic EPS = 2180/915 = $2.38

Impact of Stock Options on Diluted EPS of Colgate (Treasury Stock Method Not Used)

• Net Income 2014 of Colgate = 2,180 million
• Oustanding Shares = 915.1 million + 24.946 million = 940.046
• Diluted EPS = 2180/940.046 = $2.31

As you can see that the EPS decreased from $2.38 to $2.31 due to impact of stock options.

If the amount of stock options issued by the company is large, it can have a significant impact on the EPS of the company thereby negatively affecting the valuation of the firm. Do have a look at PE ratio for further details.

Hence, in order to minimize the impact of EPS dilution, we use the Treasury Stock Method.

Let us now try and answer the following questions –

1. What is done with the Option Proceeds? (company receives funds from the employees on exercise of options)
2. Can these Option Proceeds used in some way to reduce the impact of dilution (read Treasury Stock Method)

What is Treasury Stock Method?

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• 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

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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

Treasury Stock Method – Colgate Example

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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

What next?

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

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