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)?'

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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

16 comments:

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 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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