wDid you know that a company can own its own shares and use them to influence its earnings per share (EPS)? That’s where the Treasury Stock Method comes in.
The treasury stock method is a way to calculate how stock options, warrants, and convertible securities affect a company’s EPS.
It shows the real impact of these potential shares on the company’s financial health and capital management.
This helps investors and analysts see the bigger picture.
In this blog, you’ll learn:
- What is the treasury stock method?
- How does it work in financial modeling?
Curious about how companies handle their shares? This guide will make the concept easy to understand.
What is the Treasury Stock Method?
The Treasury Stock Method (TSM) is a way to calculate the adjusted share count (diluted shares) when a company has securities that could add more shares, like stock options, warrants, or convertible bonds.
It shows how these extra shares affect earnings per share (EPS) if they were used.
Here’s how to calculate it:
Formula: Diluted Shares Outstanding = Basic Shares Outstanding + Options/Warrants Exercised − Shares Repurchased
Where:
- Options/Warrants Exercised = Number of in-the-money options/warrants
- Shares Repurchased = Proceeds from Exercise ÷ Avg Market Price
- Proceeds from Exercise = (Exercise Price × Number of Options)
How Does the Treasury Stock Method Work in Financial Modeling?
In financial modeling, TSM predicts how potential shares from options or warrants affect EPS and valuation.
Instead of simply assuming all options increase the share base, the Treasury Stock Method adjusts for the fact that when options are converted, the company receives cash that it can use to buy back some of its own shares.
Here’s how it works step by step:
1. Assume exercising options that are worth using:
If the exercise price is lower than the current market price, it is assumed that holders will convert their options into shares.
2. Calculate cash proceeds:
The company receives cash equal to the number of options exercised multiplied by the exercise price.
3. Repurchase shares at market price:
The company is assumed to use this cash to buy back as many shares as possible from the open market (at the average market price).
4. Find the net increase in shares:
The net effect is: Net New Shares = Options Exercised − Shares Repurchased
5. Adjust the share count:
Net new shares are added to calculate the adjusted (diluted) shares outstanding.
This is then used to compute diluted earnings per share (EPS) in financial models.
Let’s understand this with an example:
Let’s say a company has:
- 100 shares are already owned by investors.
- 10 employee stock options (employees can buy shares at $20 each).
An employee stock option is like a discount coupon for future shares. It’s valuable only if the company’s stock price increases.
- The company’s stock is trading at $25.
Here’s how it works:
Step 1: Employees use their options
- They “use” their 10 options to buy shares at $20 each.
- 10 new shares are now issued.
If we stopped here, there would be 100 + 10 = 110 shares, but the company got cash when employees bought the shares.
Step 2: The Company uses cash to buy back shares
- Cash received = 10 × $20 = $200
- The company can buy back shares at $25 each (market price): $200 ÷ $25 = 8 shares
So the company buys back 8 shares from the market.
Step 3: Net effect on share count
- 10 shares were added when employees used options
- 8 shares were “taken out” when the company bought them back
- Net increase = 10 – 8 = 2 shares
This is the “net 2 shares” part: the company added only 2 extra shares to the total because it used the cash to offset most of the dilution.
Step 4: Total diluted shares
- Original shares = 100
- Net new shares = 2
- Diluted shares outstanding = 100 + 2 = 102
Even though it looks like the company is “buying shares from the market,” in reality:
- The company didn’t spend any extra cash. It only used the money it got from the employees exercising options.
- So, only 2 extra shares actually increase the total shares outstanding.
- The “buyback” just cancels out part of the dilution.
When calculating EPS, analysts don’t just use basic shares.
The Treasury Stock Method estimates the ‘true’ number of shares if all options were used, giving a more conservative EPS.
Conclusion
The Treasury Stock Method (TSM) helps analysts calculate the true number of shares a company has after accounting for options that are profitable to use.
This is why TSM is important in financial modeling.
It ensures that earnings per share and other key metrics reflect a more accurate picture of the company’s financial health.
For finance aspirants, understanding the treasury stock method is valuable because it:
- Shows how share counts and EPS can change
- Helps in analyzing company performance more accurately
- Provides insights useful for investing or financial decision-making
In short, TSM is a simple but powerful tool that links company actions, share counts, and financial modeling, and it’s worth knowing if you want to understand how companies manage their shares and value.
