The Treasury Stock Method: How In-the-Money Options and RSUs Turn Basic Shares Into the Diluted Count That Actually Prices the Equity
Michael King, PE Investment Manager · 9 min read ·
- Equity value is diluted shares × price, not basic shares × price. Dilutive securities — in-the-money options, RSUs, in-the-money convertibles — will become shares, and ignoring them understates the denominator and overstates the value per share
- The treasury stock method (TSM) is how you convert options and RSUs into net new shares. It assumes every in-the-money option is exercised, and the cash the company collects on exercise is immediately used to buy back stock at the current price. Net new shares = gross options − shares repurchased with the proceeds
- Only in-the-money instruments count. Options struck above the current price are out-of-the-money and add nothing; RSUs have a strike of roughly zero, so they are fully dilutive — every RSU is a net new share. Convertibles use the separate if-converted test, not the TSM
- The nuance that marks out a real answer: for a valuation or a deal you run the TSM at the current (spot) price off the latest option schedule; the diluted figure printed in a company’s diluted EPS denominator is a period average, computed at the average price, and is not the transaction number
Basic Shares Are the Wrong Denominator
To get from a company’s equity value to a price per share, divide equity value by the fully diluted share count — not the basic shares outstanding on the cover of the annual report. The treasury stock method is the standard way to build that diluted count: it takes every in-the-money option and RSU, assumes they are exercised, and nets off the shares the company could buy back with the exercise proceeds. Miss this step and every per-share number that follows is too high.
The reason is simple and is the entire subject in one sentence. Options and RSUs are claims on the equity that have not yet turned into shares but will. A holder of an option struck at £25 when the stock trades at £40 is going to exercise; that is 3.75 net new shares per ten options, diluting everyone already in. Valuing the business on basic shares prices the equity as if those claims did not exist. They do, and the market prices them, which is why the diluted count is the one that matters in an enterprise-to-equity bridge, a comp, or a takeover.
The Formula: Exercise, Then Buy Back at the Current Price
The mechanic rests on a single assumption — that the cash raised when options are exercised does not sit idle but is used immediately to repurchase shares in the market at the current price. That assumption is what stops the share count from ballooning by the full gross number of options and keeps only the genuinely dilutive remainder.
Two properties fall straight out of that identity and both are tested. First, the dilution from an option is the spread, not the whole option: the deeper in the money the strike, the more net shares it creates, and an at-the-money option creates almost none because the proceeds nearly fund a full buyback. Second, a rising share price cuts the buyback (each pound of proceeds buys fewer shares) and therefore increases dilution — the counter-intuitive result that a higher price means more diluted shares, not fewer.
A Worked Example: £40.00 Becomes £37.83 per Share
Numbers make the haircut visible. Take a company trading at £40.00 with 100.0m basic shares and the following equity awards outstanding.
Now push that denominator through both directions of a valuation. Going from price to equity value, diluted market capitalisation is 105.75m × £40.00 = £4,230m, against £4,000m on basic shares — a £230m gap that is real money the basic figure ignores. Going the other way, from a valuation to a per-share number, a DCF that produces £4,000m of equity value implies £40.00 per share on basic shares but £4,000m ÷ 105.75m = £37.83 on diluted shares. The same equity value, a 5.4% lower price, purely because the option pool was counted.
Options, RSUs, and Convertibles Are Not Treated Alike
The TSM is the right tool for options and RSUs; it is the wrong tool for a convertible, and conflating the two is a common tell. Each instrument has its own dilution test, and knowing which applies is half the marks.
| Instrument | Test | Net dilutive shares |
|---|---|---|
| In-the-money options / warrants | Treasury stock method | Gross options − buyback funded by strike proceeds — the spread only |
| RSUs / PSUs | Treasury stock method, strike ≈ 0 | Full amount — every unit is a share |
| Out-of-the-money options | Excluded | Zero — never exercised |
| Convertible bonds / preferred | If-converted method | The full conversion count if in the money — unless the instrument is cash-settled, when only the conversion spread dilutes |
The convertible deserves the footnote it usually does not get. A plain if-converted convert simply becomes its full share count once the stock clears the conversion price. But a modern convertible is frequently structured for net share settlement — the principal is repaid in cash and only the value above par is delivered in stock. That version dilutes only by the conversion spread, behaving far more like an option than a bond, and modelling it as a full if-converted block overstates the share count materially. The instrument’s settlement terms, buried in the indenture, decide the answer.
The Average-Versus-Spot Trap That Separates the Answers
Here is where a junior who has read the formula and a junior who has used it diverge. The diluted share number printed in a company’s accounts — the denominator of its reported diluted EPS — is computed at the average share price over the reporting period, and it is a time-weighted average of the count over the period, not a snapshot. That is the correct convention for an earnings-per-share figure that spans a quarter or a year.
It is the wrong number for a valuation or a transaction. Pricing an acquisition, a comp, or a target price is a point-in-time exercise: what does the equity cost today, at today’s price? So the analyst rebuilds the TSM at the current spot price, off the most recent schedule of options and their strikes disclosed in the filings — not the reported diluted EPS denominator, which was struck at a stale average and folds in if-converted assumptions that may not hold for a cash-settled convert. Lifting the diluted count straight from the last income statement is quick, wrong, and exactly the shortcut a good interviewer probes for.
Why It Is Never Immaterial on the Companies That Matter
The instinct is to wave the TSM through as a rounding error. On a mature industrial with a 1–2% option pool, that instinct is nearly right. On the companies where valuation is contested it is dangerous: high-growth software and biotech firms pay a large slice of compensation in equity, and option-plus-RSU pools of 5–15% of shares outstanding are ordinary rather than exceptional. At the top of that range, the difference between a basic and a diluted per-share value is larger than the premium many deals are fought over.
The through-line is that dilution is not an accounting nicety bolted onto the end of a model — it is the bridge between the equity value a valuation produces and the price a share actually commands, and it moves precisely on the names where the price is hardest to pin down. Get the denominator right and the per-share number means something; get it wrong and every decimal of precision above it is spent on the wrong base.
Take Your Preparation Further
The diluted share count is one leg of a larger machine. For where it sits in getting from enterprise value to a price per share, read the enterprise value to equity value bridge; for the instrument the TSM does not govern, convertible bonds explained; and for the valuation that most often needs a clean per-share output, how to walk through a DCF. Diluted shares also decide the denominator in every trading comp you build.
To keep the full equity-value bridge to hand, download the free EV Bridge Cheat Sheet, and for the full set of technical questions and model answers — including diluted share and equity-value walk-throughs under pressure — see the IB Interview Bible.
Ready for personalised feedback? Book a 1-on-1 mentoring session with an experienced IB/PE professional.
Frequently asked questions
What is the treasury stock method?
The treasury stock method (TSM) is the standard way to work out how many net new shares a company’s in-the-money options and RSUs add to its share count. It assumes that every in-the-money option is exercised, and that the cash the company receives on exercise (the number of options multiplied by their strike price) is used immediately to buy back shares in the market at the current price. The net new shares are the gross options exercised minus the shares repurchased with those proceeds. You add that net figure, plus RSUs in full, to basic shares outstanding to reach the fully diluted share count used to value the equity.
How do you calculate diluted shares using the treasury stock method?
Work tranche by tranche. For each in-the-money option grant, multiply the number of options by the strike price to get the exercise proceeds, then divide those proceeds by the current share price to get the shares the company can repurchase. The net new shares from that grant are the gross options minus the repurchased shares. Repeat for every in-the-money grant and sum them. Add RSUs in full (their strike is effectively zero, so there is no buyback to offset them), exclude any options struck above the current price, and add the total to basic shares outstanding. For example, 10.0m options struck at £25 with the stock at £40 raise £250m of proceeds, buy back 6.25m shares, and net to 3.75m new shares.
Why are RSUs fully dilutive but options are not?
The difference is the strike price. An option holder pays the strike to exercise, and that cash funds a partial buyback under the treasury stock method, so the option dilutes only by the spread between the strike and the current price. An RSU (restricted stock unit) has a strike of effectively zero — the holder pays nothing to receive the share — so there are no proceeds and no offsetting buyback. Every RSU therefore becomes one full new share. That is why a company with a large RSU pool dilutes more than one with the same number of options struck close to the current price.
When do you use the treasury stock method versus the if-converted method?
Use the treasury stock method for options, warrants, RSUs and PSUs — instruments that are exercised or settled for shares, where notional exercise proceeds can fund a buyback. Use the if-converted method for convertible bonds and convertible preferred stock: assume the instrument converts into its full share count if it is in the money (above the conversion price), and remove the associated interest or dividend from earnings. The one important exception is a convertible structured for net share settlement, where the principal is repaid in cash and only the value above par is delivered in shares — that dilutes only by the conversion spread, much like an option, and should not be modelled as a full if-converted block.
Why does a higher share price increase the number of diluted shares?
Because a higher price shrinks the buyback that offsets the exercised options. Under the treasury stock method the exercise proceeds are fixed by the strike price, but those proceeds buy fewer shares when the market price is higher — so fewer shares are retired and more net new shares survive. It is counter-intuitive, but a rising stock price means more dilution, not less. It also means the diluted count in a company’s reported diluted EPS, struck at the period’s average price, understates the current diluted count whenever the share price has risen since — which is one reason a valuation rebuilds the treasury stock method at the current spot price rather than lifting the figure from the accounts.