Cogito

Diluted EPS: Treasury Stock Method

Posted in CFA by qmarks on April 18, 2010

Under US GAAP when a company has stock options, warrants or their equivalents outstanding, the diluted EPS is calculated using the treasury stock method. In other words what EPS would have been if the options had been exercised and the company had used the proceeds to repurchase common stock. In order to explain it to a lay man, I will benefit from a very simple example, if you are already aware of Treasury Stock Method, that may sound basic.

Let’s start with a fictitious company with a market cap of $500.

It has 10 shares outstanding each @ $50

Also it has 2 options outstanding which gives the holder the right to buy common shares at $25

Since the option is in the money, the holder may exercise this option so he purchases common stocks at $25. Evidently, he has to pay $25 for each share he wants to purchase, in total that makes $50 (2 option x $25)

Then the company uses that $50 proceeds to buy 2 shares in exchange of 2 options. But as you are aware he can only buy 1 shares with the proceeds he receive from the option holder. Thus, he has to issue one more share. Ergo, the number of shares outstanding will raise from 10 to 11.

The Diluted EPS calculation using the treasury stock method is based on the argument above. It is simply the Net Income over number of new shares outstanding (after the options are converted)

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