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Treasury Stock Method

Definition

The Treasury Stock Method is a way of calculating the number of new shares that can potentially be created by un-exercised in-the-money options and warrants. It assumes that the proceeds a company receives from an in-the-money option exercise are used to repurchase common shares in the market. The net increase in shares outstanding is used in the calculation of diluted earnings per share (EPS).

Phonetic

The phonetic pronunciation of “Treasury Stock Method” is:Tre-zhuh-ree Stok Meth-id

Key Takeaways

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  1. Non-dilution of Common Stock: The Treasury Stock Method assumes that exercise of in-the-money stock options and other dilutive securities would lead to buying back of common shares at the average market price, avoiding dilution of stock. This theory assumes that the company is not to face a net increase in shares outstanding.
  2. Financial Statement Representation: In financial statements, treasury stock shows as a deduction from the total issued shares. The method ensures that a company’s earnings per share (EPS) are not affected by its outstanding options or convertible securities.
  3. Increased Earnings Per Share (EPS): The usage of the Treasury Stock Method may lead to an increase in a company’s reported earnings per share as the deemed proceeds are assumed to repurchase shares at the average share price. Thus, fewer shares remain outstanding, which in turn, increases the earnings per share ratio.

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Importance

The Treasury Stock Method is an essential concept in business and finance as it helps in determining the potential dilution of shares if in-the-money stock options were to be exercised. It assumes that the proceeds received from the in-the-money options are used to purchase common shares at the market price. It plays a crucial role in calculating the weighted average number of shares, which is used in financial metrics like Earnings Per Share (EPS). Hence, for firms granting options to employees or contemplating stock buyback, understanding and applying the Treasury Stock Method becomes critical in evaluating dilution impacts on shareholder value, maintaining daily financial operations, and strategic planning.

Explanation

The Treasury Stock Method is a staple in financial analysis and specifically serves the purpose of calculating the potential dilution of shares that a company might experience as a result of outstanding in-the-money options and warrants. This method is designed to provide shareholders and potential investors with a clearer understanding of the company’s financial health. In this context, dilution refers to the decrease in the proportion of each existing shareholder’s equity due to the issue of additional shares. It becomes critical when gauging the potential impact of employee stock options (ESOs), warrants, and other securities on the earnings per share (EPS) of listed companies.The Treasury Stock Method is applied under the assumption that the proceeds a company receives from in-the-money option/warrant exercises are utilized to repurchase common shares in the market. Therefore, the net increase in the number of shares outstanding is reduced, which can help minimize EPS dilution. It’s important to note, the Treasury Stock Method is a theoretical approach, and actual company practices upon options/warrant exercises can vary. Nevertheless, it significantly contributes to understanding the potential impact of these securities on a company’s overall capital structure.

Examples

The Treasury Stock Method is a method of computing potential increase in common shares that could occur due to in-the-money stock options, convertible securities, rights, and warranties. It is used to calculate the diluted earnings per share, which assumes that all options and convertible securities have been exercised.Here are three real-world examples within the context of businesses:1. **Google Inc.:** In 2012, Google announced a special kind of dividend to its shareholders in the form of shares. These shares were part of the treasury stock, which Google had repurchased previously. Google utilized the treasury stock method to determine the potential impacts of issuing new shares on their EPS (Earnings Per Share).2. **Ford Motor Company:** Ford has historically used the treasury stock method especially in relation to their employee and executive compensation plans. For instance, when options are granted to employees, the increase in outstanding shares can dilute EPS. Ford uses the treasury stock method to calculate the potential dilution and in light of this, has made decisions about its treasury stock.3. **Twitter Inc.:** After its IPO in 2013, Twitter acknowledged that they would utilize the treasury stock method to account for the dilution of shares due to grants of options and awards under their 2013 Equity Incentive Plan. The company emphasizes in its filings that this particular method would provide a clearer picture of its diluted EPS.

Frequently Asked Questions(FAQ)

What is the Treasury Stock Method?

The Treasury Stock Method is an approach used in financial calculations to determine the number of new shares that could potentially be created by un-exercised in-the-money stock options and warrants. This method is used for the computation of diluted earnings per share (EPS).

How is the Treasury Stock Method used in financial calculations?

The Treasury Stock Method is used to calculate the diluted earnings per share (EPS) for a company. It assumes that the proceeds the company gets from in-the-money stock options and warrants are used to repurchase common shares in the market. The net increase in shares is then added to the BASIC EPS share count.

What are the main steps in the Treasury Stock Method?

There are three main steps. Firstly, the total amount of in-the-money options is calculated. The method assumes these options are exercised, so the company receives the exercise price from option holders. Secondly, the method assumes the company uses these proceeds to buy back shares from the market. The number of shares that the company could buy back is calculated. Thirdly, the net increase in shares (total in-the-money options less buyback shares) is added to the denominator of the diluted EPS calculation.

Can negative diluted EPS result from the Treasury Stock Method?

No. The Treasury Stock Method will only increase the number of shares or leave them unchanged. It assumes any options or warrants in the money are exercised, thereby increasing the company’s stock. This can dilute EPS, but it does not result in negative EPS.

Why is the Treasury Stock Method important in financial analysis?

The Treasury Stock Method is crucial in financial analysis because it provides a more accurate picture of a company’s financial health by accounting for potential dilution of earnings per share. As such, it is commonly used by analysts and investors when analysing the EPS of public corporations.

Does the Treasury Stock Method apply to out-of-the-money options or warrants?

No. The Treasury Stock Method only applies to in-the-money options and warrants, i.e., those where the current market price of the stock is greater than the exercise price of the option or warrant. Out-of-the-money options are not counted as they are not likely to be exercised.

What is the difference between basic and diluted EPS?

Basic EPS is calculated by dividing the net income by the number of outstanding shares. Diluted EPS, on the other hand, takes into account the potential increase in outstanding shares due to in-the-money options and warrants. The Treasury Stock Method is used to calculate the diluted EPS.

Related Finance Terms

  • Earnings per Share (EPS): A profitability indicator used by investors, calculated by dividing net income by the number of shares outstanding. It’s significantly affected by the treasury stock method.
  • Dilutive Securities: These are securities that are not common stock in form but allow the owner to obtain common stock upon exercise, for instance, stock options and convertible bonds. They are integral in the treasury stock method.
  • In-the-Money Options: These refer to stock options with an exercise price less than the fair market value of the underlying stock. It’s a vital concept in the treasury stock method as only in-the-money options create dilution.
  • Outstanding Shares: These are the shares held by shareholders including retail investors, institutional investors, and insiders. The treasury stock method impacts the number of these shares.
  • Treasury Shares: These are shares bought back by the issuing company, reducing the amount of stock available on the open market. The treasury stock method assumes such shares are used for exercising options and convertible securities.

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