The treasury stock method is a method used to predict the potential dilutive effect of dilutive securities on a company’s earnings per share. Dilutive securities include convertible bonds, convertible preferred stock, warrants, and employee stock options.

Under the treasury stock method, companies compute the number of new shares that may potentially be created by unexercised in-the-money options and warrants. This is done by taking the exercise and strike price of a diluted security (an in-the-money security with an exercise price that is lower than the company’s current stock price) and determining the total number of shares of common stock that could be acquired if the security were exercised.

To illustrate this, let’s assume a company has a diluted security with an exercise price of $6 and a current share price of $10. If the security were exercised, the company would receive $6 worth of cash in exchange for each share of common stock purchased. The number of shares of common stock that could be potentially created is the exercise price divided by the current share price; in this example, 0.60 shares. To calculate the total number of shares of common stock that could be created, the company would multiply the number of diluted securities by the number of shares that could be created by exercising each security.

The theoretical principle behind the treasury stock method is that the proceeds received from an in-the-money option exercise are used to repurchase common shares in the market. This effectively reduces the number of outstanding shares and therefore eliminates potential dilution that would have occurred had the securities been exercised.

The treasury stock method is beneficial to companies that may potentially issue a large number of dilutive securities. By systematically buying back shares in the market, companies are able to minimize the potential dilutive effect of their dilutive securities on the company’s earnings per share. In some cases, companies may use the proceeds from an in-the-money option exercise to directly buy back common shares, but this is less common.

As mentioned before, the treasury stock method is used by companies when calculating their diluted earnings per share (EPS). By accurately predicting potential dilution of the company’s earnings, companies can better assess the true financial performance of their operations. This is especially important for publicly traded companies as the impact of dilution can drive down share prices.

In summary, the treasury stock method is used to predict the dilutive effect of dilutive securities such as options, warrants, and convertible bonds on a company’s earnings per share. The method assumes that the proceeds from an in-the-money option exercise are used to repurchase common shares from the market and helps companies accurately assess their financial performance. This is important for publicly traded companies, as the effect of dilution can have a significant impact on the share price.