What Is the Treasury Stock Method and How Is It Used?
Uncover the method used to assess the potential future effect of equity-linked obligations on a company's reported shares.
The Treasury Stock Method is an accounting technique used to estimate the potential dilutive effect of certain equity instruments on a company’s shares outstanding. This method enhances transparency in financial reporting by presenting a scenario where the company hypothetically repurchases shares to counteract potential dilution. It is particularly important for investors evaluating a company’s per-share earnings.
Understanding Diluted Earnings Per Share
Earnings Per Share (EPS) is a fundamental metric indicating how much profit a company generates for each outstanding share of its common stock. It is a widely used measure of profitability and a key indicator for investors. Basic EPS is calculated by dividing a company’s net income (minus preferred dividends) by the weighted average number of common shares outstanding.
The concept of “dilution” arises when a company has financial instruments that can be converted into additional common shares. This increases the total number of shares outstanding, which can reduce the ownership percentage of existing shareholders. Dilution effectively spreads the company’s earnings over a larger number of shares, potentially decreasing the earnings per share.
Diluted Earnings Per Share (Diluted EPS) is a more conservative measure that accounts for this potential conversion of certain securities into common stock. It provides a picture of the company’s per-share earnings if all potentially dilutive instruments were exercised. Companies are required to report Diluted EPS under Generally Accepted Accounting Principles (GAAP) to offer a more realistic view of per-share earnings, assuming all potential shares were issued.
Fundamentals of the Treasury Stock Method
The Treasury Stock Method (TSM) is a conceptual approach used to calculate the impact of potentially dilutive securities on a company’s shares outstanding. The central premise is that any proceeds a company receives from the exercise of dilutive securities are used to repurchase its own common stock in the open market. This hypothetical repurchase occurs at the average market price of the common stock during the reporting period.
The method applies only to instruments that are “in-the-money,” meaning their exercise price is less than the average market price. If the exercise price is higher, instruments are “out-of-the-money” and would not be exercised, thus having no dilutive effect. Only in-the-money instruments are included in the TSM calculation.
The Treasury Stock Method is a theoretical calculation of potential dilution, not an actual transaction where a company buys back shares with exact proceeds. This hypothetical repurchase aims to mitigate the dilutive effect by reducing the number of shares that would otherwise be added to the outstanding common stock.
Calculating Diluted Shares Using the Method
Applying the Treasury Stock Method involves a series of steps to determine the net increase in shares outstanding due to dilutive securities. The process begins by identifying all in-the-money dilutive securities, such as stock options or warrants.
Steps for Calculation
Determine the total number of shares that would be issued if all identified in-the-money dilutive securities were exercised. For instance, if 100,000 options are in-the-money, then 100,000 shares would theoretically be issued.
Calculate the hypothetical cash proceeds the company would receive from this assumed exercise. This is done by multiplying the number of shares that would be issued by the exercise price of the dilutive securities. For example, if 100,000 options have an exercise price of $10, the hypothetical proceeds would be $1,000,000.
Determine the number of shares the company could hypothetically repurchase with these proceeds. This amount is calculated by dividing the hypothetical cash proceeds by the average market price of the company’s common stock during the reporting period. Using the previous example, if the average market price is $20, the company could hypothetically repurchase 50,000 shares ($1,000,000 / $20).
Calculate the net increase in shares outstanding. This figure is derived by subtracting the number of shares hypothetically repurchased from the number of shares that would have been issued upon exercise. In the example, the net increase would be 50,000 shares (100,000 shares issued – 50,000 shares repurchased).
Add this net increase to the basic number of shares outstanding to arrive at the total diluted shares outstanding, which is used in the diluted EPS calculation.
Instruments Applicable to the Method
The Treasury Stock Method is typically applied to equity instruments that have the potential to increase a company’s outstanding common shares upon their exercise or conversion. These instruments are referred to as dilutive securities. The most common examples include stock options and warrants.
Stock options grant the holder the right, but not the obligation, to purchase a company’s common stock at a predetermined price, known as the exercise or strike price, within a specific timeframe. When exercised, new shares are typically issued, increasing the number of shares outstanding and potentially diluting existing shareholders. Warrants are similar to stock options but are generally issued by the company itself, often in conjunction with other securities, and also allow the holder to purchase shares at a set price.
These instruments are subject to the Treasury Stock Method calculation because their potential exercise directly impacts the denominator of the earnings per share calculation. Other instruments, such as certain convertible securities like convertible preferred stock or convertible bonds, can also have a dilutive effect and may be factored into diluted share calculations.