Wednesday, May 14, 2008

The Treasury Stock Method

Here is another interview question I was asked in my last interview: 'How do you calculate equity value using the Treasury Stock Method (TSM)?'


Let's go over the answer to this question.

This question relates specifically to one of the first steps of performing a Public Comparable Analysis. In this type of analysis the banker needs to Calculate Equity Value. There are typically two ways to do this.

  • Equity value = Share price x Shares outstanding

  • Treasury Stock Method, which also includes calculating options and their equivalents

Note: Only in-the-money options are used when performing the TSM calculation. For an option to be in-the-money, the option's strike price must be less than the current stock price. When performing this calculation you are also assuming that a rational investor will exercise their in-the-money option, allowing them to make the 'spread'.

Another assumption of the TSM is that the money the company makes by all holders exercising their in-the-money options will be used to buy back stock.

So how do you perform the actual calculation?

Steps to Calculate Equity Value Using the TSM

STEP 1 ) Options proceeds = Exercise price x Options outstanding

STEP 2 ) Shares repurchased = Options proceeds / Current stock price

STEP 3 ) Diluted shares outstanding = Basic shares + In-the-money options - Shares repurchased under TSM

STEP 4 ) Equity value = Diluted shares outstanding x Current stock price

Memorize these 4 basic steps to perform this calculation, know and understand the assumptions, and you will be a star in your interview when you are asked this question.

Here are some more links on this topic for your reference:

Wikipedia: Treasury Stock Explained

Investopedia: Treasury Stock Method


Albina N muro said...

Investment banking technical interview question using treasury stock method to calculate dilutive shares for valuation comparable company analysis. gold ira accounts

Eapen K C said...

Thank you. I have a doubt on STEP 3, When the Company repurchases shares using in-the-money proceeds, are they not purchasing from the total outstanding shares in the market. If yes how does it add to the total diluted shares outstanding. I might be wrong here but could you please let me know. Many thanks. Eapen(+918105159357)

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