Earnings Per Share: Treasury Stock Method - YouTube

Okay, the third thing I want to look at now is called the Treasury Stock Method.

So, with the Treasury Stock Method, this deals with options, rights, warrants.

So, this is like a stock option.

Let's think about a stock option, if you had a stock option, what happens?

Options, warrants, you have these things that allow you to convert it, give money, and get

common stock back.

So, if you think about it, what are you giving me?

You're giving me money.

What am I giving you?

Common stock.

So whether it's an option, whether it's a right, whether it's a warrant, I've got to

look at that and use what we call the Treasury Stock Method.

Now listen carefully, this is what we're doing, theoretically.

Again, you may never even exercise the option, right or warrant.

But, theoretically, what is earnings per share?

Theoretically speaking, if we distribute all our money, how much would you get per share?

So, here's what happens.

If you gave me a stock option, what happens?

You'd exercise the option, give me some money.

I would then give you stock.

But, I want to minimize the dilutive effect.

So here's what I do.

I go out on the open market and I buy back my own stock.

What's that called?

Treasury stock.

Then, minimizing the dilutive effect.

So, if I gave you four shares, but you're gonna give me less money than market price,

right, because, otherwise you wouldn't exercise it, it would be anti-dilutive.

I then take the money go out and buy it back at the average market price.

Therefore, that would be the difference.

So, really I would just look at the incremental difference.

So if you gave me money and I spent it all, how much money do I have left to give away?

If I took all the money, and I gave it away, then I would have nothing left.

So, I would have zero money left.

But, in the denominator, I would add in something called, plus the incremental number of common

stock outstanding at the average market price.

That's what I would have to add back.

The incremental number of outstanding, at the average market price.

And the average market price means, on average, how much was the stock trading for during

that year?

That's what average market price is.

So, let's say for example, I had 40,000 options.

And let's say they were converted into 40,000 shares of common stock.

So you can convert those into 40,000 shares of common stock.

Now, you're going to give me 15 dollars a share of as the option price.

You're gonna give me 600,000 dollars, cool!

But, you gave me 600,000 but let's say the average market price is 20 dollars a share,

that means I could only buy back 30,000 shares of Treasury Stock.

That means, that you gave me 600,000, I theoretically took the money went out and bought my stock

at 20 dollars a share.

Now notice, is it dilutive?

Yeah, because the option price is 15 and the market price is 20.

Would you give me 15 if I gave you 20?

Yes.

Would you give me 20 if I gave you 15?

No, that's anti-dilutive.

So, what we're doing, is you theoretically give me 15, I then give you 40,000 shares

of stock.

I go out on the average market, and I buy back, theoretically, I spend all 600,000.

So when I spend it all, how much money's left?

Zero, so I have zero to add in the numerator.

However, I'm gonna take that, go out and buy back, how much?

30,000 shares.

What is the incremental number of shares outstanding?

10,000.

So what it theoretically means is, you gave me 600, I spent 600, zero left.

I had 40,000 I gave you, I bought back 30, what's the incremental change?

10,000.

So, if you add nothing in the top and 10,000 in the bottom, obviously, what does that do

to everyone's earnings per share?

It drops it, it dilutes it.

So, that's what we're looking at.

So that is called the Treasury Stock.

So, number three here is gonna be the Treasury Stock Method.

And the Treasury Stock Method that is for options, rights, and warrants.

Now, remember warrants, we had bonds with detachable, preferred stock with detachable.

We have stock options going to whom? Employees.

We have rights going to whom? Stockholders.

These allow people ... So, what do we do?

We include them.

And, again, it doesn't matter if you really converted, why?

Could you convert?

Yes.

Is it advantageous economically?

Yes.

Then we assume you did whether you really did or not.

That's how it fits in.

That's called the Treasury Stock Method.

I understand that it's confusing, but let's do it again.

You have 40,000 options, if you exercise them, you're gonna give me 15 bucks a share.

As long as the market price is more than 15, it's dilutive, we have to include it.

So what do we say?

If you exercised them, you would've given me 600,000, I would've given you 40,000 shares

of common stock.

I would then theoretically take the money, theoretically go out and buy back my stock

at how much?

The average common stock market price.

I go out and buy back only 30,000, incremental number.

In the top zero, in the bottom I would add in 10,000, which is this.

And that would obviously do what to earnings per share?

It would decrease everybody's earnings per share.

That is considered to be dilutive.

All right, so that is what you're doing.

You're gonna make that change today.

So, that is called the Treasury Stock Method and it's an important concept to understand.

That one doesn't get as tested as much.

But let's kind of look at the big picture again.

What have we learned so far?

We start out here with basic.

What is basic?

Simple.

It says there's no potentially dilutive securities.

You have net income minus preferred dividends.

Preferred dividends, if they are cumulative whether declared or not, if they're non-cumulative,

only if declared.

You divide that by the weighted average number of common stock outstanding.

Weighted number of common stock is calculated, how?

Over here.

We're going say dividends and splits are treated retroactively.

You take your numbers and you weight them.

How much of the year were they outstanding?

That's called weighted average.

This whole year, this three quarters of the year, this retroactive, this Treasury Stock

came out of here so it's how much they weren't outstanding.

Two for one split hits everything.

Plus, anything retroactive goes back to all the previous years also presented.

Okay, so we take our net income, minus preferred is the dollars, divide it by that.

You then take this number, bring it over and adjust it by two numbers.

You take this over and adjust it by two.

The first adjustment is called the If Converted Method.

The If Converted Method is for convertible bonds, convertible preferred stock.

What does it say?

It's say, "If you convert, what would happen?"

If it's preferred, you wouldn't have to pay it add it back in, not net of tax.

If it's bonds, add it back in, net of tax.

In the denominator, add in the number of common stock shares that it was converted into.

And usually they'll tell you that or you have to calculate it.

But it tells you, "The preferred converted to this, the bonds converted to that."

Then the denominator, number of shares.

The third method is called the Treasury Stock Method for options, rights, and warrants.

What is says is theoretically if you exercise your option, right or warrant, you give me

money, what do I do?

I give you stock.

Then, I want to minimize the dilutive effect.

So I gave you 40,000 shares but I'm gonna then take that theoretical money go out and

buy back stock at the average market price.

Then, I'm gonna buy fewer shares.

So, if I spent all the money, I've got zero left.

What's left is the incremental number which is 10,000 plus incremental number of common

stock outstanding at average market price.

Divide that.

That's how you get your diluted earnings per share.

So, again it's called basic, it's called diluted, those are the two different things we're gonna

have to look at.

Those are required to be shown where?

On the face of your income statement.

So, where?

For income from continuing and from net income, and, the DE, discontinued, disposal and extraordinary,

you can show either for both as well in the face or also in the footnotes.

Okay, so, that's an important concept.

This goes hand-in-hand with stockholder's equity because they'll take net income, you

need to calculate your shares outstanding, and that's kind of where it gets tested.

I like to break it apart separately so we can kind of walk through little baby steps,

baby steps through accounting.

That's how we get through it.

That's how we learn.

That's how we live it, love it, learn it, okay?

In a couple of minutes, we'll apply all of this and we'll do some questions.