Stock options give an employee the right to buy shares of a company’s stock at a set price, which would potentially dilute the firm’s stock or increase the number of shares outstanding. This has a negative effect on stockholders because it reduces each stockholder’s portion of ownership interest in the company. You can use the treasury stock method to calculate the potential dilution of a company’s stock based on its outstanding employee stock options. The method assumes a company repurchases its own stock with the proceeds it receives from the options to reduce its share count and minimize the effect of dilution.
Determine the number of a company’s outstanding stock options and their exercise price, the price at which the options entitle an employee to purchase a share of stock. For example, assume the company has 10,000 stock options outstanding with an exercise price of $1 per share.
Determine the number of the company’s outstanding shares throughout the past year and its average stock price during the past year. In this example, assume the company had 100,000 shares of stock outstanding during the past year and that its average stock price was $2 per share.
Multiply the number of stock options by their exercise price to calculate the proceeds that the company would receive if all stock options were exercised. In this example, multiply 10,000 by $1 to get $10,000 in proceeds.
Divide the proceeds from the stock options by the average stock price to calculate the number of shares of treasury stock the company would buy with the proceeds. In this example, divide $10,000 by $2 to get 5,000 shares of treasury stock that the company would purchase with the proceeds.
Subtract the number of shares of treasury stock from the number of shares the company would issue if all stock options were exercised to calculate the incremental amount of shares the stock options would add to the number of shares outstanding. In this example, subtract 5,000 from 10,000 to get 5,000 incremental shares.
Add the number of incremental shares to the shares outstanding during the past year to calculate the new number of shares outstanding if the stock options were to be exercised. In this example, add 5,000 to 100,000 to get 105,000 shares outstanding if all the stock options were to be exercised.
You can calculate a company’s earnings per share or your percentage ownership in the company based on the new amount of outstanding shares after the dilution effect of outstanding options.