Intel Corp (INTC)

[DewDiligence]

Addendum on options accounting:

sgolds, Elmer, et al: We all know that EPS is a fraction with earnings in the numerator and the number of shares in the denominator. Adjusting only the denominator to account for options, as the GAAP “diluted” share count does (for in-the-money options), is of course better than no adjustment at all – but such an adjustment solves only half of the problem because the numerator has not been adjusted.

Consider a simple example of a company which has a net worth of $1B, 100M diluted shares outstanding, annual earnings of $50M, and an annual expansion of 5% in the diluted share count from option exercises. The book value of this company at our starting time is the net worth divided by the diluted share count: $1B/100M = $10/sh.

Under GAAP, this company would appear to be profitable during the year in question because its EPS would be $50M/1.05B = $0.048. But in reality, the sample company is adding no economic value for its shareholders and is merely treading water. Here’s why:

After one year, the $50M in earnings will increase the company’s net worth from $1B to $1.05B. This $1.05B divided by the new share count of 105M produces the same $10/share book value that the company had at the beginning of the year.

In summary, GAAP produces a positive EPS even though shareholders have realized no change in the book value. The problem arises because the $50M in GAAP earnings which goes in the EPS numerator is a bogus figure which has not taken into account the economic cost to shareholders of the expansion in the share count. FWIW. Dew