Circularity in Treasury Stock Method
Hi all,
Could someone please explain how there is circularity created which affects the share price of a company due to the increase in NOSH (number of outstanding shares).
Thank you very much.
A
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I’m not exactly sure what you mean, but I’ll take a stab at it. Share price fluctuations can can cause options/warrants to be in or out of the money and because of that the number of fully diluted shares outstanding is dependent on share price which moves constantly? Not sure if this helps but saw no else gave an answer yet.
Hi, thanks for that! I understand that share price movements would cause options to be in/out of the money. However, I don't see how the share price is an input for calculating diluted NOSH.
Thank you in advance for your help!
Here is an extract from the book I am reading:
DCF valuation can be adjusted to produce a diluted equity value per share as the dilution considers exercising the in-the-money (ITM) options. The ITM is calculated using the implied equity value per share (undiluted) as the reference price to determine whether or not the share options are in or our of the money.
Dilution can be estimated using Treasury Stock Method.
The dilution creates circularity in the DCF model as the dilution will increase in the NOSH used to calculate the equity value per share. The dilution in the share price will therefore affect the ITM options calculation.
The dilution will in turn affect the NOSH and so there is circularity.
Not sure exactly how to explain it, but I'll try my best (from what I understand) - assuming you know TSM. In a DCF you're going to, at some point, calculate an implied share price. You can only calculate that implied share price by first using the TSM. The number of in-the-money options depends on the implied share price (this is what it seems like from the excerpt you posted). But to get the implied share price you have to first do TSM, bringing you back to square one.
That (I believe) would be the circularity. You can't calculate one with out first calculating the other. Not sure if that helps or not.
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