How does the treasury stock method work for calculating the dilutive impact of stock options on EPS?

The treasury stock method (TSM) estimates the dilutive impact of stock options and warrants on EPS by assuming that in-the-money options are exercised and the proceeds are used to repurchase shares at the average market price. Only the net incremental shares increase the denominator.\n\nStep-by-Step Mechanics:\n\n1. Assume all in-the-money options are exercised at the beginning of the period (or grant date if later)\n2. Calculate total proceeds the company would receive (shares x exercise price)\n3. Assume the company uses those proceeds to buy back shares at the average market price for the period\n4. The difference between shares issued and shares repurchased equals the incremental dilutive shares\n\n`mermaid\ngraph TD\n A[\"Options Exercised
Shares Issued: N\"] --> B[\"Proceeds Received
N x Exercise Price\"]\n B --> C[\"Repurchase Shares
Proceeds / Avg Mkt Price\"]\n C --> D[\"Incremental Shares
= Issued - Repurchased\"]\n D -->|\"Positive\"| E[\"Dilutive
Add to denominator\"]\n D -->|\"Negative or Zero\"| F[\"Anti-dilutive
Exclude\"]\n`\n\nComprehensive Example:\n\nSummitRidge Financial has the following data for 2026:\n\n| Item | Value |\n|---|---|\n| Net income | $22.5M |\n| Weighted average basic shares | 8,000,000 |\n| Average market price during 2026 | $60 |\n\nThree tranches of options outstanding:\n\n| Tranche | Options | Exercise Price | In-the-Money? |\n|---|---|---|---|\n| A | 300,000 | $40 | Yes |\n| B | 200,000 | $55 | Yes |\n| C | 100,000 | $72 | No — exclude |\n\nTranche A:\n- Proceeds: 300,000 x $40 = $12,000,000\n- Shares repurchased: $12,000,000 / $60 = 200,000\n- Incremental shares: 300,000 - 200,000 = 100,000\n\nTranche B:\n- Proceeds: 200,000 x $55 = $11,000,000\n- Shares repurchased: $11,000,000 / $60 = 183,333\n- Incremental shares: 200,000 - 183,333 = 16,667\n\nTotal incremental shares: 100,000 + 16,667 = 116,667\n\nEPS Calculations:\n- Basic EPS: $22.5M / 8,000,000 = $2.81\n- Diluted EPS: $22.5M / (8,000,000 + 116,667) = $22.5M / 8,116,667 = $2.77\n\nWhy Average Market Price (Not Year-End)?\n\nUsing the average price reflects the price at which shares could have been repurchased throughout the period, not just at one point. This produces a more representative measure of dilution experienced over the entire reporting period.\n\nCommon Mistakes:\n- Using year-end price instead of average price\n- Forgetting to exclude out-of-the-money tranches\n- Including all options rather than just those outstanding during the period (time-weight if granted mid-year)\n- Double-counting when options and warrants coexist\n\nMaster treasury stock method calculations in our CFA FRA practice modules.