Treasury Stock Method: A Step-by-Step Worked Example (With Numbers)

If an interviewer asks you to "walk me through diluted shares" and you freeze, you're not alone. The treasury stock method (TSM) sounds technical, but it's really a short bit of arithmetic built on one simple story.

In this post, we'll build that story, run a full worked example with real numbers, and then add the M&A twist that interviewers love to throw at candidates. By the end, you'll be able to do it on a whiteboard without breaking a sweat.

Why Diluted Shares Matter in the First Place

When you calculate a company's equity value, you multiply share price by shares outstanding. The catch is which share count you use.

Companies often have securities that could turn into common stock later:

• Stock options (employees can buy shares at a fixed strike price)
• Warrants (similar to options, often issued to investors or lenders)
• Restricted stock units (RSUs)
• Convertible bonds or convertible preferred stock

If you ignore these, you understate the true number of shares and the true equity value. The treasury stock method is how bankers handle options and warrants.

The Story Behind the Treasury Stock Method

Here's the logic in plain English. Imagine every option holder whose option is in the money exercises today.

1. Option holders pay the strike price to the company and receive new shares.
2. The company now has cash from those exercises.
3. The company uses that cash to buy back shares at the current share price.
4. Net new shares = shares issued from exercise minus shares repurchased.

The buyback step is what makes it the "treasury" stock method: repurchased shares sit in treasury. The buyback partially offsets the dilution, so the net impact is smaller than the raw option count.

The Formula

For each tranche of in-the-money options:

Net new shares = Options − (Options × Strike Price ÷ Current Share Price)

Or the shortcut version, which is handy for mental math:

Net new shares = Options × (1 − Strike ÷ Price)

Key rule: only include options where strike price < share price. Out-of-the-money options wouldn't be exercised, because nobody pays $60 for a stock trading at $50.

Worked Example: Calculating Diluted Shares Outstanding

Let's use a fictional company, TargetCo.

The facts:

• Basic shares outstanding: 100 million
• Current share price: $50.00
• Options outstanding:

• RSUs: 0.5 million

Step 1: Check Which Options Are In the Money

Compare each strike to the $50 share price:

• Tranche A ($20): in the money ✅
• Tranche B ($40): in the money ✅
• Tranche C ($55): out of the money ❌, so it's excluded

Step 2: Run Tranche A

• Shares issued on exercise: 2.0 million
• Cash proceeds: 2.0 million × $20 = $40 million
• Shares repurchased: $40 million ÷ $50 = 0.8 million
• Net new shares: 2.0 − 0.8 = 1.2 million

Shortcut check: 2.0 × (1 − 20/50) = 2.0 × 0.6 = 1.2 million. Same answer.

Step 3: Run Tranche B

• Shares issued on exercise: 1.5 million
• Cash proceeds: 1.5 million × $40 = $60 million
• Shares repurchased: $60 million ÷ $50 = 1.2 million
• Net new shares: 1.5 − 1.2 = 0.3 million

Notice how much less dilutive Tranche B is. The strike is close to the share price, so the company raises almost enough cash to buy back nearly every new share.

Step 4: Add the RSUs

RSUs have no strike price, so there are no proceeds to fund a buyback. In a simple banking model, you typically add the full count:

• Net new shares from RSUs: 0.5 million

Step 5: Add It All Up

Step 6: Calculate Diluted Equity Value

• Basic equity value: 100.0 million × $50 = $5,000 million
• Diluted equity value: 102.0 million × $50 = $5,100 million

That's a $100 million difference. In a valuation or deal, ignoring it would be a real mistake.

The M&A Twist: Use the Offer Price, Not the Current Price

This is where a lot of candidates slip up. In an acquisition, the buyer pays an offer price per share, usually at a premium. You run the treasury stock method at that offer price, because that's the price at which options would actually be exercised and cashed out.

Let's say an acquirer offers $60 per share for TargetCo.

Redo Each Tranche at $60

• Tranche A ($20): 2.0 × (1 − 20/60) = 1.333 million
• Tranche B ($40): 1.5 × (1 − 40/60) = 0.500 million
• Tranche C ($55): now in the money! 1.0 × (1 − 55/60) = 0.083 million
• RSUs: 0.500 million

The New Totals

• Purchase equity value: 102.417 million × $60 ≈ $6,145 million

Three things changed when the price went up:

• Tranche C flipped from out of the money to in the money.
• Every tranche got more dilutive, because a higher price means the proceeds buy back fewer shares.
• Total dilution rose from 2.0 million to about 2.42 million shares.

The takeaway: a higher share price always means more dilution under TSM. That's a great one-liner to have ready.

Quick Notes on Other Securities

The treasury stock method isn't the whole picture. Keep these straight:

• Warrants: treated exactly like options. Same formula.
• Convertible bonds and convertible preferred: use the if-converted method instead. If converting is worth more than holding (the conversion price is below the share price), you add the shares from conversion and remove the related debt or preferred from your capital structure, so you don't double count.
• Accounting vs. valuation: for reported diluted EPS, accountants apply TSM using the average share price over the period. In valuation and deal work, bankers use the current price or offer price.

Common Mistakes to Avoid

• Including out-of-the-money options. If strike ≥ price, the tranche adds zero.
• Lumping all options together at a weighted average strike. Run each tranche separately. Averaging can make out-of-the-money options look in the money, or vice versa.
• Using the current price in an M&A deal. Use the offer price.
• Forgetting RSUs. They're a big chunk of dilution at many tech companies.
• Not checking options vs. exercisable options. Filings often show both. Many bankers use all outstanding in-the-money options, especially in M&A where vesting often accelerates, but know which one you're using and why.

How to Answer This in an Interview

If you get "How do you calculate diluted shares using the treasury stock method?", try something like:

"First, I identify which options and warrants are in the money. For each tranche, I assume they're exercised, so the company issues new shares and receives the strike price as cash. The company then uses that cash to repurchase shares at the current share price, or the offer price in a deal. The net new shares are the shares issued minus the shares repurchased. I add those to basic shares, plus RSUs and any in-the-money convertibles using the if-converted method."

Then, if they hand you numbers, use the shortcut Options × (1 − Strike ÷ Price). It's fast, clean, and hard to mess up under pressure.

The Bottom Line

The treasury stock method is just one story: options get exercised, cash comes in, shares get bought back. Run it tranche by tranche, include only in-the-money securities, and use the right share price for the situation.

Practice the TargetCo example once or twice from memory. Once the numbers feel automatic, this question goes from a stumbling block to an easy point in your interview.