Treasury Stock Method for Diluted EPS from Employee Options
Summary
The document explains how employee stock options can increase diluted earnings per share through the treasury stock method. Option holders pay the exercise price to the company and receive shares. The company is assumed to use the exercise proceeds to repurchase shares at the average market price, reducing the net increase in shares counted in diluted EPS.
In the example, 802 options with an exercise price of 6 produce proceeds of 4,812. At an average share price of 10, those proceeds could repurchase about 481 shares. The remaining 321 shares represent the assumed net dilution. The explanation clarifies that the option holders are employees or other recipients, rather than the company itself, and that shares may be sourced through repurchases or newly issued stock. The calculation is an EPS convention; it does not describe the company’s actual choice of funding or share issuance.
Key ideas
- Employee option holders pay the exercise price to the company when exercising their options.
- The treasury stock method assumes the company uses exercise proceeds to repurchase shares at the average market price.
- Diluted EPS counts the options’ net share increase after the hypothetical repurchase.
- The assumed net shares can be newly issued or sourced through a market purchase, depending on the company’s actions.
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# Computing the denominator of diluted earnings per share # Computing the denominator of diluted earnings per share I'm practicing for CFA level 1, and I faced this question. I don't understand the last part (802 − 481 = 321) because I understand that a company doesn't realize options of its own shares, if you are the owner of those options, you realize them at 6, get those 4812 dollars, buy 481 shares at price $10. So: - Those shares are purchased in the market (if not where?), then why would the company need to issue more shares? - The question seems to assume the company has those options. Is this actually possible? It doesn't make sense to me that the company has options (why would it have them in the first place?) - Why is the 802 - 481 actually mean? If I realize those 802 options, and buy the 481 shares, it's actually fewer shares than options. I just don't get it. > Assume that the exercise price of an option is 6, and the average market price of the stock is 10. Assuming 802 options are outstanding during the entire year, the number of shares to be added to the denominator of diluted earnings per share (EPS) is closest to: Answer Proceeds from the exercise of the options would be: (802)(6) = 4,812 The number of shares that could be repurchased with the proceeds at the average price is: 4,812 / 10 = 481.2 The additional number of shares the company would need to issue to fulfill the stock options is: 802 − 481 = 321 ## Answer by Bob Jansen (score 2, accepted) https://quant.stackexchange.com/a/67763 I think your misunderstanding arises from who is holding the options. The options are not held by the company itself but by others, e.g. employees, who received the options as a form of compensation. The option holders will exercise the options paying exercise price of 6 and receiving one stock for each option from the company. The payments by the option holders earn the company $6 \times 802 = 4,812$. The company can use this to buy $4,812 / 10 = 481.2$ shares in the open market. However, the companies needs to give the option holders 802 stocks in total. Therefore, they need to come up with $802 - 481 = 321$ shares. The company can do this in two ways: - Buy these in the open market but this requires financing; or - Create new shares Apparently, in this question, the second option is chosen and 321 shares are created, leading to dilution of the existing shareholders.
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