What is the Treasury Stock Method?
Treasury Stock Method assumes that the options and stock 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 the 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 stock warrantsStock WarrantsA Stock Warrant gives the holder the right to buy the company's stock at a predetermined price in a specific time period, and when the holder exercises the right, the holder buys the company's stock and the company receives the money as its source of capital..
- 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 a 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 the anti-dilutive effect occurs. In the latter case, exercise is not assumed.
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 priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market. (X) of $2 and the current market price (CMP) of $2.5. Calculated the diluted EPS.
Assume tax rate – 40%
Basic EPS Example
Denominator = 100,000 (basic shares) + 10,000 (in the money options) – 8,000 (buyback) = 102,000 shares
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 shareDiluted Earnings Per Common ShareDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc. is calculated using the “treasury stock method. With this, we may assume that 15.746 may be related to the buyback using the Option Proceeds.
Treasury Stock Method Video
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