Treasury stock method
Valuation & CompsThe convention for counting in the money options: assume exercise, assume the proceeds buy shares back, and count only the difference.
Also written: TSM, diluted shares
Options that are in the money will become shares, so they belong in the count used for equity value and for any per share figure. The treasury stock method assumes every in the money option is exercised, that the exercise proceeds are used to repurchase shares at the prevailing price, and that only the net new shares are added.
The method is not a rough approximation. It is arithmetically identical to adding the exercise proceeds to equity value and dividing by the full undiluted plus option count, which is a useful second route for checking your own work.
The trap is that the repurchase price is the share price, so the diluted count depends on the price. When the price is what you are solving for, the reported diluted count in the accounts is the wrong count, because it was built at the traded price rather than at your implied one. A higher implied price means the same proceeds repurchase fewer shares, so the correct count is larger and value per share is lower.
Options out of the money are excluded, which means a company can become materially more dilutive on good news without issuing anything. The same logic governs a convertible: out of the money it sits in the bridge as debt, in the money it converts and joins the count, and it must never appear in both places.
Worked example
100 million basic shares and 10 million options struck at 20. At a traded price of 25 the 200 of proceeds repurchases 8 million shares, so the count is 102 million.
An equity value of 4,200 over 102 million is 41.18, but at 41.18 the proceeds would not have bought back 8 million shares. Solve properly: at 40.00 the proceeds repurchase 5 million, the count is 105 million, and 4,200 over 105 million is exactly 40.00.
Check it the other way: 4,200 plus 200 of proceeds, over the full 110 million shares, is also 40.00. The market based count overstated the answer by roughly three percent.