Explain the treasury stock method for diluted shares and when you'd use the if-converted method instead.
A core Valuation interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
The treasury stock method (TSM) handles in-the-money options/warrants: it assumes they're exercised, the company receives the strike proceeds, and uses that cash to buy back shares at the current price — so the net new shares are the gross exercised shares minus the shares repurchased. Net dilution = options × (1 − strike/price) for in-the-money instruments; out-of-the-money ones are ignored. You use TSM for options and warrants in the diluted share count for equity value and per-share metrics. The if-converted method applies to convertible bonds/preferred: you assume conversion into shares (adding the full conversion shares) and, correspondingly, remove the after-tax interest/preferred dividend from earnings — you use whichever (converted vs not) is more dilutive. So TSM for options (net-settled cash-in), if-converted for convertibles (full share add-back with the interest reversal).
WHAT INTERVIEWERS LISTEN FOR
- ✓TSM: exercise options, use proceeds to buy back shares, net new shares
- ✓Net dilution = options × (1 − strike/price); ignore out-of-money
- ✓If-converted for convertibles: add full shares, reverse after-tax interest
- ✓Use the more dilutive of converted vs not
COMMON MISTAKES
- ✗Adding gross option shares with no buyback offset
- ✗Using TSM for convertible bonds
- ✗Forgetting the interest add-back in if-converted
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