The Treasury Stock Method

If a company has issued stock options, exercising them would create new shares, diluting existing shareholders — but not by the full number of options outstanding, because the company also receives cash when those options are exercised. The treasury stock method assumes that cash is immediately used to buy back shares at the current market price, so only the net new shares count toward dilution.

The method only applies to options that are "in the money" — where the market price is above the strike price — because out-of-the-money options would not rationally be exercised and add no shares.

Worked example. A company has 1,000,000 options outstanding with a $20 strike price, and its stock trades at $25. Exercising all options brings in 1,000,000 x $20 = $20,000,000 in cash. At the current $25 price, that cash could buy back $20,000,000 / $25 = 800,000 shares. Net new shares added to the diluted count are therefore 1,000,000 - 800,000 = 200,000, not the full million.

The method understates dilution when a stock's price is only briefly elevated, and it produces zero dilution automatically once the stock falls back below the strike, since those options simply stop being counted.