The treasury stock method is a method that companies employ to calculate the number of shares which could possibly be created through unexercised warrants and options that are in-the-money when the exercise price is lower than the price of shares currently in circulation. The additional shares that are created through the treasury stock method are included into the calculations of dilute profits per share (EPS). It is assumed that profits a business receives from an exercise of an option in the money can be used to repurchase ordinary shares in the marketplace.
Understanding the Treasury Stock Method
The treasury stock model stipulates that the fundamental share count that is used to calculate the company’s earnings per share (EPS) is required to be increased due to the existence of outstanding options in the money and warrants that allow their owners to buy common shares at a price that is less than the current market value. To conform to generally accepted accounting practices (GAAP) using the treasury stock method should be utilized by a business when calculating its diluted earnings.
This approach assumes that warrants and warrants exercised at the start of the period and the company utilizes exercise proceeds to buy common shares at an average market value during the period. The number of shares that need to be added to the share count is determined by an amount that is different between share count from the option and warrants exercise, and the number of shares of shares that might have acquired in the market.
Example of Treasury Stock Method
Take a look at a company that has the following: 100,000 base shares in circulation with $500,000 net earnings for the previous period, as well as 10,000 cash-in-hand warrants and options, and an average exercise cost of $50. Let’s suppose that the market average for shares during the previous one year was 100. If we take the share count for 100,000 common shares, the basic EPS of the company is $5, which is calculated as the net earnings equal to $500,000 divided into 100,000 shares. This number does not consider the possibility that 10,000 shares could be issued instantly if warrants and options in the money are granted.
If the method is based on treasury stocks using the treasury stock method, the business would be able to receive $500,000 as exercises proceeds (calculated as 10,000 warrants and options times an average price for exercise of $50) and could be able to use to purchase common shares of 5,000 in the open market for the cost of $100.
The additional 5 000 shares (the difference between the 10,000 assumed issued shares and the assumed repurchased share of 5,000) are the net newly issued shares as a result of the possible exercises of warrants and options.
The dilute share count is 105,000 equals 100,000 basic shares plus five additional shares. The diluted EPS will be equivalent $4.76. $4.76 equals $500,000 in net income/105,000 shares diluted.