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Treasury Stock Method: Definition
The treasury method is a method that companies employ to determine the amount of shares which could possibly be created through unexercised warrants and options in the money, when they exercise at a price lower than the value of the shares at the moment. 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 company earns from an exercise in cash can be used to repurchase common shares on the market. The treasury method declares that the base share count that is used to calculate earnings per share (EPS) will be increased by the result of outstanding options in the money and warrants that permit their holders to purchase common shares at a price that is less than the market value. In order to comply with generally accepted accounting practices (GAAP) using the treasury stock method should be employed by a firm in computing its diluted earnings per share.
This approach assumes that warrants and warrants exercised at the start of the period and a company makes use of exercise proceeds to buy common shares at a market price for that time. The number of shares to be added to the base share count is calculated by what is the ratio between share count from the option and warrants exercise, and the number of shares of shares that might have acquired through the market.
An example of Treasury Stock Method
Take a look at a company that has the following: 100,000 base shares in circulation and $500,000 in net income over the last period, as well as 10,000 in-the money warrants and options, and an average exercise cost of $50. Let’s say that the market average for shares during the past calendar year was $100. Based on the share count for 100,000 common shares, the basic EPS of the company is $5, calculated as the net profit equal to $500,000 divided into 100,000 shares. This number does not consider the possibility that 10,000 shares could be issued immediately if in-the-money warrants and options are granted.
If the method is based on treasury stocks The company will 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 55,000 common shares on the market for the cost of $100.
The additional five thousand shares (the difference between the 10,000 assumed issued shares and the assumed repurchased share of 5,000) represent the net newly issued shares that result from the possibility of exercise of warrants and options. The number of shares diluted is 105,000 equals 100,000 basic shares plus five additional shares. The diluted EPS will be equivalent $4.76. $4.76 ($500,000) net income/105,000 shares diluted.