Contents - Index

Concept 2:  Future Residual Income
©2009 OS Financial Trading System



Residual earnings is expressed as a dollar excess return defined as follows:
Residual Earningst = Return on Common Equityt - (Cost of equity capital * Book value of common equityt-1)
In the above the Return on Common Equityt (ROCEt) is defined as Comprehensive Earningst/Book Value of Common Equityt-1.
The two drivers of residual income are ROCE and Book Value plus to forecast residual income over time requires an assessment of growth behavior estimates. 
IBM Example:  The 10-K filings from IBM provide the source data as follows:
 


Source 2008 10-K IBM SEC Filing
From the above the TTM Earnings per share = 5398 + (12334 - 5084) = 12648
$12,648/1,310.88  = $9.64848 and as computed earlier in section IV the Book Value per Share equals $11.73258.
For Residual Income we are interested in Comprehensive income.  This is defined as follows:
Comprehensive income = Net income + Other Comprehensive income
In 2008 10-K IBM does not report "Other Comprehensive income" but if looking closer at the changes in the Shareholders' Equity statement in IBM's 2008 10-K reports there is a significant line item ($18,431) that largely arises from net changes in retirement benefit plans ($14,856) and Foreign currency translation adjustments ($3,552).


From the above IBM's Comprehensive Income is actually negative for 2008 because "Other Comprehensive Income" is ($18,431).  If we check the TTM estimate from the latest quarterly Balance Sheet we observe a similar picture:


That is from the latest quarterly Balance Sheet  the  amount has declined slightly to 21,043.  However, this adjustment also includes the exchange rate fluctuations which are expected to fluctuate both negatively and positively over time.  So no real change we will work with the annual data.  
Looking at the last two years the major components of Other Comprehensive Income are $5487 in 2007 and ($18,431) in 2008.  If we take the average of these two figures we get ($6472).  Averaging over time this is driven primarily by pension expenses which are re-occur over the normal course of business.  These expenditures represent the human capital component of Capital Expenditure.  As a result,  
The Comprehensive income that we will apply for valuation purposes is:
Comprehensive income = $12,648 + ($6472) = $6176 
Comprehensive Earnings per share = $6,176/1,310.88   = $4.7113 and as computed earlier in section IV the latest TTM Book value per share = 15,380/1,310.88 = $11.73258 per share.
Growth in Book Value per Share
To project residual earnings over time we further need to assess the growth behavior of the book value per share.  This requires combining information about earnings growth rates as well as dividend policy which we will now focus attention on.
Current dividend information available from Yahoo reveals the current trailing annual dividend rate to be $2.10 per share:


Dividend per Share = $2.10.
Dividend Payout Ratio (Relative to Comprehensive Earnings) = $2.10/$4.7113 = 0.4457
Comprehensive Earnings per share = $4.7113
However, we will need to work with next year's dividend which needs to be forecast.  One approach to this is to apply the dividend payout ratio to next year's forecast earnings.  We consider earnings forecasts next.
What is the consensus abnormal growth forecast for IBM? 
Here we will check two general sources from the web Yahoo Finance and MSN Money.  These numbers are constantly revised over time in response to changes in the economy.  At the time of this current example:
Yahoo Finance



MSN Investor



From the above the reported consensus forecasts for earnings are:
Current Year (FY2009):   9.77% and   9.78%
FY 2010:  10.67% and 10.68%
5-year projection:  9.33% and 13.60%
The two sites agree for the 1- and 2-year projections (within rounding) but for 5-year MSN usually adjusts more frequently their reported growth numbers so we could place a little more weight on the MSN numbers.  However, we will be conservative and use the 5-year average (9.33+13.60)/2 = 11.465%.  
In a two stage abnormal growth model growth behavior is accurately forecast out for some period of time which is usually 5-years.  Then a simplifying assumption is made that the income grows in perpetuity at some constant rate.  This constant rate is referred to as the normal growth rate.  The normal growth rate is constrained by economy wide growth as we cannot assume that a stock grows in perpetuity at a greater rate than this constraint.  Otherwise, the stock (in the distant future) is implied to grow larger than the economy as a whole - a contradiction.
Normal Growth Example:  We will use 4.5% for the stage 2 normal growth estimate as a conservative long term average growth rate for IBM.  This number can be justified from long term macroeconomic data for the US economy. 
First, refer to the following Government report.  Long Term Growth in the US:  In a 2005 Report to Congress on Long Term Growth for the US economy.   The following quote was given:
<http://www.ftsmodules.com/public/modules/ftsRT/projects/longtermgrowth.pdf>
"We also observe over the last 100-year span that the rates of economic growth across the then emerging industrial nations were fairly tightly clustered around this 2.0% pace. At the high end was Japan with an annual rate of growth averaging about 2.7%, while at the low end was Great Britain with an annual growth rate averaging 1.4%. The United States, which grew at a 1.8% average annual rate, was slightly below average."

They also went on to observe:

"For the United States, the long-term growth of real GDP per capita over the last 125 years has revealed remarkable steadiness, advancing decade after decade with only modest and temporary variation from the observed 1.8% annual rate of increase."

Inflation has been a fact of life for the U.S. economy.   Inflation numbers suggest that inflation compounded from 1913 to 2008 resulted in a cumulative rate of 2071.23%  This, implies an annual constant compounded rate of approximately 3.24%. 
Combining the above we can make a reasonable estimate for one plus the long term nominal growth in the US, to be around 1.018*1.03 = 1.04854.  As a result, to be conservative we will use as an upper bound for economy wide growth for US stocks (i.e., the stage 2 growth rate) the rounded down number of 4.5%.  
Current Year (FY2009):   9.77% and   9.78% (= 9.775%)
FY 2010:  10.67% and 10.68% (= 10.675%)
5-year projection:  9.33% and 13.60%.  Average = 11.465%

Current Summary of Key Inputs:
Book value per share = 15,380/1,310.88 = $11.73258 per share.
Dividend per Share = $2.10.
Dividend Payout Ratio (Relative to Comprehensive Earnings) = $2.10/$4.7113 = 0.4457
Earnings per share =$12,648/1,310.88  = $9.648
Comprehensive Earnings per share = $4.7113
Comprehensive EPS 1 year from now  $4.7113*1.09775 = $5.1718, Growth 0.09775
Comprehensive EPS 2-years from now  $4.7113*1.09775*1.10675 = $5.724, Growth 0.10675
5-Year  Growth = 0.11465
Normal Growth = 0.045
Projected Dividend Per Share (Next Year - forward annual dividend rate e.g., Yahoo.com) = $2.20
Years in Abnormal Growth Stage 1:  5-years
We next turn our attention to the discount rate - that is assessing IBM's Cost of Equity Capital.