To use the Treasury Stock Method, we first need a tally of the company’s issued stock options and weighted average exercise prices. We get this information from the company’s most recent 10K. If our calculation will be used for a control based valuation methodology (i.e. precedent transactions) or M&A analysis, we will use all of the options outstanding. If our calculation is for a minority interest based valuation methodology (i.e. comparable companies) we will use only options exercisable. Note that options exercisable are options that have vested while options outstanding takes into account both options that have vested and that have not yet vested.
Once we have this option information, we subtract the exercise price of the options from the current share price (or per share purchase price for an M&A analysis), divide by the share price (or purchase price) and multiply by the number of options outstanding. We repeat this calculation for each subset of options reported in the 10K (usually companies will report several line items of options categorized by exercise price). Aggregating the calculations gives us the amount of diluted shares. If the exercise price of an option is greater than the share price (or purchase price) then the options are out-of-the-money and have no dilutive effect.
The concept of the treasury stock method is that when employees exercise options, the company has to issue the appropriate number of new shares but also receives the exercise price of the options in cash. Implicitly, the company can “use” this cash to offset the cost of issuing new shares. This is why the diluted effect of exercising one option is not one full share of dilution, but a fraction of a share equal to what the company does NOT receive in cash divided by the share price.