8.11  Application IBM Step 2:  Comprehensive Income

Residual income is dollar excess return over what is required by investors in terms of the cost of equity capital times book value of shareholders equity.  As a result, it can be expressed as follows:

 In the above the Return on Common Equity_t (ROCE_t) is defined as:

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 Consolidated Income Statement filings from IBM provide the source data as follows:

 Source: 2009 10-K IBM SEC Filing

From the above the Earnings per share = $13.425/1.341 = $10.011 and as computed earlier the Book Value per Share equals $16.881.

For Residual Income we are interested in Comprehensive income.  This is defined as follows:

Comprehensive income = Net income + Other Comprehensive income

In the 10-K statements the last three years for “Other Comprehensive Income” is available in the Shareholders Equity Statement. 

Conceptual Note:

In dirty surplus accounting some items are adjusted to the stockholder’s equity as opposed to the income statement.  The main three items are:  foreign currency translation, pension liability and hedge accounting adjustments.  As a result, these items can fluctuate from year to year and so we will take the average over the three years provided in the 10-K as a first pass for “Other Comprehensive Income.”

The three years provided (2009, 2008 and 2007) respectively are:

Important Note:  Recall that in this exercise we are interested in calculating Comprehensive income for valuation purposes.  That is, we want to estimate sustainable comprehensive income such that we can apply growth behavior to in order to project the future behavior of comprehensive income.  In practice this requires some judgment calls and in this case it is evident that the year to year fluctuations are large for Other Comprehensive Income.  As a result, to provide an estimate that is likely to be sustainable we take the average:

The Comprehensive income that we will apply for valuation purposes is: