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Treasury Stock Method: Formula & Examples

The Treasury Stock Method is a technique used to calculate Diluted Earnings per Share (EPS).

5 minute read

One of the main concerns for investors is whether a company will dilute their equity by issuing more new shares. After all, the more shares there are, the more people you need to share the profit and company value with, thus reducing your size of the pie.

This risk of being crowded out by new shareholders is known as equity dilution risk, and investors have developed several techniques for managing it. In this article, we will focus on one popular example, known as the Treasury Stock Method (TSM).

What is the Treasury Stock Method?

The Treasury Stock Method is a technique used to calculate Diluted Earnings per Share (EPS). Before delving further, let’s pause to make sure we understand what this means.

Earnings per share and Equity Dilution

Earnings Per Share (EPS) is a financial ratio calculated as:

EPS = Company’s Profit / Total Number of Shares Outstanding

It is one of the most popular metrics in finance, but if you think about it, EPS can be misleading. What if a company has been increasing its profits but ends up issuing a large number of new shares? In that scenario, EPS could decline even though profits are increasing, since the denominator (share count) would drag down the number.

Now, you might be asking why a company would choose to issue new shares in the first place. ‍

Well, in some cases companies rely on selling shares as a form of ongoing fundraising. This is very common in pre-revenue companies (such as new technology companies). For these companies, issuing new shares is part of the business model. It’s simply expected that they will need to keep selling shares until they are able to start generating revenue and profits.

But what about companies that are already profitable?

‍‍Even for them, equity dilution can be a concern. For instance, a profitable company might issue new shares to finance an acquisition, or as part of a convertible debt issuance. Or, perhaps most common, it could have offered stock options to its employees as part of their compensation package. In these situations, the actual amount of shares outstanding (the number used for EPS) could be significantly lower than the amount of shares that would be outstanding if all those stock options and other instruments were to be exercised.

Since equity dilution is such a significant risk, investors developed a new metric, Diluted EPS, which recalculates shares outstanding after assuming that all potentially dilutive instruments are exercised. The Treasury Stock Method is a technique that is used to calculate Diluted EPS, especially in situations where the company has a lot of stock options or warrants.

Understanding the Treasury Stock Method (TSM)

With this background in mind, let’s dive deeper into exactly how investors calculate Diluted EPS using the Treasury Stock Method (TSM). Rather than being a single formula, it’s more accurate to think of the TSM as a series of steps that investors go through. Those steps are:

Identify any securities that could be profitably converted into shares. Securities that are “in the money” are very likely to be exercised, such as when the company’s share price is above the strike price of an employee’s stock options. The employee in this example would likely exercise the option (meaning, exercise their right to buy shares) because it would be profitable for them to do so (the shares they receive would be worth more than they pay for them).
Calculate what the company would get if those securities were indeed exercised. This involves adding up all the “in the money” securities and multiplying them all by their individual exercise prices.
Estimate how many of its own shares the company could buy back using that money it receives from the exercised securities. This is a key point, and is the reason why the term “treasury” is used at all. Imagine you are the company, and you just received a lump sum of cash from various investors choosing to exercise their securities and receive shares. What do you do with the cash? The TSM assumes that you would use the cash to buy back as many of your own shares as possible, thereby limiting the amount of dilution that occurs. These repurchased shares are known as "treasury shares" because they're held in the company's treasury and do not carry voting rights or pay dividends.
After deducting those repurchased shares, calculate the net increase in share count. In other words, you take the total number of shares created from step 1 and then deduct the number of shares repurchased in step 3.

After going through these steps, you arrive at the number of additional shares outstanding, which is sometimes referred to as the “Net Dilution”. You then add this number to the denominator of your EPS calculation, to arrive at Diluted EPS:

Diluted EPS = Net Income / (Shares Outstanding + Net Dilution)

Note that, although the TSM assumes (in step 3) that the company would use all the available proceeds to buy back its own shares, this may not be true in practice. After all, there are many other uses the company could find for that capital, such as for acquisitions and capital expenditures (CAPEX), paying down debt, or simply retaining it as cash. Moreover, even if the company does use the cash to buy back shares, this would not happen instantaneously as it does in the TSM. As is often the case in finance, the TSM uses simplifying assumptions that are not technically true in the real world.

Treasury Stock Method vs If-Converted Method

While we are on the subject, there are a few other real-world nuances for you to be aware of. First, although the TSM is a common way to calculate Diluted EPS, it is not the only one. For example, if the company has a lot of convertible bonds or convertible preferred shares, then investors may instead use the “If-Converted Method”, which involves a different calculation process. In fact, if the company has a wide range of different potentially dilutive securities, it may be necessary to use multiple calculation methods for diluted EPS, and then combine the end results together to form a complete picture. This would likely be overkill for most purposes, but would be more common among professional analysts.

Treasury Stock Method: In the Money vs Out of the Money

Another nuance to be aware of is that investors will sometimes take different approaches to step 1 of the TSM process. Specifically, some investors will only consider options that could be exercised profitably today (“in the money” options, also known as “exercisable options”), whereas others will deliberately include all options, even those that are “out of the money”. These out-of-the-money options are also referred to as “outstanding options”. Using the outstanding options in the calculation will give a more conservative (lower) number for diluted EPS, because it will raise the Net Dilution even further (since more new shares are included).

Treasury Stock Method Example Calculation

Now that we’ve explored the TSM in theory, let’s apply what we’ve learned with a concrete example.

Suppose we are analyzing a technology start-up called XYZ Tech. It is currently trading at $20 per share. It has 1 million shares outstanding and net income of $5 million, so its EPS (before considering any potential dilution) is $5 per share

EPS = Net Income of $5 million / (Shares Outstanding of 1 million) = $5.00

Now, we want to calculate how we might be affected by any potential dilution that might occur after our investment. After digging deeper, we discover that XYZ Tech has relied heavily on employee stock options as part of their strategy for retaining skilled employees. Specifically, they have issued 200,000 options to their employees, with an average exercise price of $10 per share. In this example, we’ll assume that each option corresponds to one share, meaning the employee would pay $10 in order to purchase one share of stock. Following our steps from earlier, let’s apply the Treasury Stock Method (TSM) to calculate our Diluted EPS.

First, we’ll figure out how many dilutive securities there are and how much cash the company would receive if they were exercised. In this instance, we can see that all of the 200,000 options would likely be exercised, since their exercise price ($10 per share) is less than XYZ Tech’ current market price ($20 per share). Therefore, the company would receive $2 million from the exercise of the options (200,000 options x $10 per option).
Second, we would assume that XYZ Tech takes that $2 million and uses all of it to repurchase its own shares. How many shares could it repurchase? With a market price of $20 per share, it could repurchase 100,000 shares. Note that we are assuming the market price is not affected in the process, which of course may not be the case in the real world.
Lastly, we would then calculate our Net Dilution, which in this case would be 100,000 shares (200,000 new shares issued, minus 100,000 shares repurchased). We can then apply this figure to calculate our Diluted EPS, as follows:

Diluted EPS = Net Income of $5 million / (Shares Outstanding of 1 million + Net Dilution of 100,000) = $4.55

So in this example, while the basic EPS of XYZ Tech was $5 (corresponding to a price-to-earnings ratio of 4), the diluted EPS is $4.55 (PE ratio of 4.4). Using the Treasury Stock Method in this manner helps us avoid overpaying for companies that might be affected by equity dilution in the future.

That being said, it’s always important to remember that calculations like these rely on simplifying assumptions, and that the actual real-world events will depend on unpredictable factors such as the actual behavior of the options holders and the company itself.

Additional Resources

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