To understand the treasury stock method, you must first understand some of the factors in business accounting that require its use. The treasury stock method is used to measure diluted earnings per share for a business. This is consistently applied by any company using Generally Accepted Accounting Priniciples (GAAP), which all companies trading public securities must use. GAAP standardized how a company keeps its books so, when an investor considers purchasing a security from that company, the public information on the corporation is based on a standard metric.
Earnings Per Share
Earnings per share is an expression of how much of a company's profit is allocated to its shareholders in a given period of time. It is calculated by the simple equation: Net Income - Dividends / Average Outstanding Shares. The number of shares outstanding varies for any corporation over a period of time. This occurs when the company issues additional shares or repurchases common shares back from the public. Earnings per share is an indicator of performance, and it is often used as a tool for evaluating the success of a particular company over a given period of time. Higher earnings per share, naturally, is a good factor.
Diluted Earnings Per Share
Earnings per share does not account for outstanding convertible securities the company may have on the market at any given time. Basically, this means there may be convertible preferred shares, employee-based stock options or warrants on the company's securities still floating around the market, currently unexercised. It is very rare for a company to have zero convertible securities outstanding. For a shareholder, though, diluted earnings per share could be much lower than standard earnings per share because the diluted model takes into account the fact there are many more potential outstanding shares on the market that could be exercised at any moment.
Treasury Stock Method
The treasury stock method is the formula used to account for convertible shares outstanding in the diluted earnings per share model. This formula assumes that all profits from in-the-money shares will be used to repurchase common shares from the marketplace. "In-the-money" simply refers to any options that will net a profit for the company. So, both call options and put options can qualify as in-the-money shares if the company will profit from exercising the option. The profits are then used for the company itself to buy up outstanding common shares on the market. It adds to the total number of shares outstanding, increasing the denominator in the diluted earnings per share equation, and lowering that number for investors.
Application of the Treasury Stock Method
The treasury stock method is complicated, but it can be understood in a simple, every day scenario. Imagine two adults give a group of 5 children $50 to spend at an ice cream store for a birthday party. The amount each individual can spend is $10. However, the adults actually sent out 10 invitations. At any moment, 5 more children could come, and the amount each individual can spend would be $5. The treasury stock method assumes those additional children will show up.