Treasury Stock Method: Diluted Shares Formula & Worked Example
How does the treasury stock method calculate dilution?
For in-the-money options, assume exercise, calculate the cash proceeds, and use those proceeds to repurchase shares at the assumed market price. Net incremental shares equal options exercised minus shares hypothetically repurchased.
The repurchase is a calculation assumption, not a claim that the company actually buys shares. Keep exercise proceeds, strike price and share price separate. This simplified interview exercise covers options only.
The formula
Incremental shares = options × (1 − strike price ÷ share price), when the options are in the money. Diluted shares = basic shares + incremental shares. Use consistent share units; if basic shares are millions, option counts must be millions too.
Original worked example
Suppose there are 40 million basic shares and 4 million options with a $15 strike price. At a $25 share price, exercise proceeds are 4 × 15 = $60 million. The assumed repurchase is 60 ÷ 25 = 2.4 million shares. Net dilution is 4 − 2.4 = 1.6 million shares, giving 41.6 million diluted shares.
Out-of-the-money options
If the strike price is above the assumed share price, do not force negative incremental shares into the model. In this simplified method, out-of-the-money options are excluded. Actual diluted EPS analysis involves instrument terms, period averages and anti-dilution rules.
Do not count gross options as net dilution
Adding all 4 million options directly to basic shares would ignore the repurchase assumption. Using the strike price for the repurchase would also be wrong: proceeds arise at strike, but the hypothetical repurchase occurs at the market price.
A useful follow-up
How does dilution change as the share price rises with strike and option count held constant? Exercise proceeds stay fixed, so fewer shares can be repurchased and incremental dilution rises. Distinguish this point-in-time valuation exercise from period-based diluted EPS and from RSUs or convertible securities.
Put it into practice
Work through an original scenario, check the calculation and concept, then try fresh inputs.
Start this practice exercise →Related guides
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Prepared by Accretive Thinking. Original fictional examples. Calculations checked; qualified expert review pending. Educational practice, not investment advice.