WHAT IS THE FAIR VALUE OF THE DOW JONES INDUSTRIAL AVERAGE ("DJIA")?
 

This page provides:

1. The Dow Jones Industrial Average  P/E ratio (based on trailing and forward earnings)

2. Earnings on the Dow Jones Industrial Average (GAAP, operating and forward earnings)

3. Dividend Yield on the Dow Jones Industrial Average

4. A link to the P/E , earnings and dividend information on the the Dow Jones web site

5. Calculations of the fair value of the Dow Jones Industrial Average based on several scenarios

Mathematically, the Fair Value of the Dow Jones Industrial Average depends on the return that investors require, the growth in earnings, and the probable P/E ratio at which it could be sold at the end of a reasonable holding period of say 10 years.

This article provides a range of values depending on the scenario chosen. The author believes that a fair value for the DJIA is between 7,543 and 10,750 with a mid-point of 9,146.

This analysis is dated December 13, 2009. However the calculated fair value of the Dow Jones Industrial Average (DJIA) is not affected by the precise date of the analysis and our fair value mid-point estimate of 9,146 will not change before the next set of quarterly earnings numbers becomes available for the DJIA.

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A quick indication of whether or not the Dow Jones Industrial Average is fairly valued is to look at its P/E ratio. At this time the P/E ratio (based on actual reported earnings in the past year) of the DJIA index is  16.8. This is about neutral in attractiveness. Therefore the quick indication is that the DJIA index is about fairly valued as December 13. 2009 at this time at 10,471.

This article explores the fair value of the DJIA in much more detail below.

Importantly, an analysis of the fair value of the Dow Jones Industrial Average (DJIA) will not provide a short-term indicator of market direction but it should provide a rough indicator of the fair value of the DJIA and a long-term indicator of the expected return from investing in the DJIA at this time.

The attractiveness of the current DJIA level can be judged by looking at the current level of its earnings and dividends, forecasting a reasonable future rate of earnings and dividend growth and by considering the minimum expected return required by investors. Analysts often apply this valuation technique to individual stocks. It is actually far easier to apply these calculations to a stock index since an index constitutes a portfolio. A portfolio automatically eliminates much (and usually most) of the random noise of unexpected events at individual companies through diversification. Still, many challenges remain in applying this analysis and therefore its results while providing some indication for the long-term can offer no real insight for the short-term. A broad index like the DJIA remains vulnerable to changes in interest rates and to uncertain growth (or shrinkage) in the economy but is usually largely insulated from the numerous random events that can impact an individual stock.

What is the Earnings and P/E ratio of the Dow Jones Industrial Average right now? (December 13 with the index at 10,471)

Data from the Dow Jones company itself provides four different answers to the above question based on different views of the earnings on the DJIA.

DJIA Earnings Type	Annual Earnings on Dow Industrials	P/E Ratio at 10,471 DOW	Earnings Yield
Actual latest year (trailing four quarters) GAAP earnings	$623	16.8	5.95%
Latest year operating  earnings (removes negative earnings)	$663	15.8	6.33%
Forecast forward GAAP earnings for the next year (next four quarters)	$764	13.7	7.30%
Forecast forward operating earnings for the next year (removes negative earnings)	$764	13.7	7.30%
For Comparison here are the DJIA earnings in prior years:		Historical GAAP P/E	Historical Earnings Yield
2008 Actual GAAP Earnings	$661	13.3	7.52%
2007 Actual GAAP Earnings	$831	16.0	6.25
2006 Actual GAAP Earnings	$720	17.3	5.78%
2005 Actual GAAP Earnings	$476	22.5	4.44%
2004 Actual GAAP Earnings	$592	18.2	5.49%

In order to calculate a fair value of the Dow Jones Industrial Average, it is necessary to start with its current earnings level and to make sure that this current earnings level is "representative" of "normal" expected economic conditions and has not been materially affected upwards or downwards by usual items.

Unfortunately, the actual trailing GAAP earnings on the DJIA have in fact probably been distorted downwards by extremely large and unusual loses at a few large companies like Alcoa. There is also the general lowering of earnings due to recession. One possibility is to look at the earnings level from 2007. However those earnings were likely above the trend line as indicated by the red line in the graph below.

 In our view a fair and perhaps conservative estimate of the "representative" earnings level on the DJIA in the past year is the trailing operating earnings of $663. This is well below the actual earnings of 2007 and also somewhat below the actual earnings of 2006.  2007 and 2006 represented "top of the cycle" earnings and so a representative earnings somewhat below those levels may be reasonable particularly given the recession conditions.

This $663 is 20% below the earnings from 2007 and 8% below the 2006 earnings and therefore it does not seem unrealistically high at all. Also it is about equal to the 2008 actual GAAP earnings which reflected a certain amount of unusual losses. Our $663 may be moderately too low when we consider that these earnings should recover somewhat from recession levels. However we also note that the DOW earnings were not hurt as badly by the recession as the S&P 500 earnings were and therefore we should expect a smaller recovery for the DOW.

The following graph provides additional insight into the representative or normalized level of the DJIA earnings.

Note that we use a logarithmic scale on this chart. Logarithmic shares should always be used when the time period is more than about 30 years because otherwise the lines will turn up exponentially.

The above chart shows that the earnings on the DOW trend up with the U.S. GDP although at a slightly lower rate and with substantial volatility around the trend.

The next chart presents the same data but starting in 1980 and using a regular arithmetic scale so that we can more closely examine the graph over more recent years.

The last point on the chart is the earnings  and GDP in the 12 months ended Sept 2009. The earnings have dipped noticeably since reaching a peak in 2007. The GDP figure is not yet showing a dip but is showing a flat spot. Note that the GDP figures here are in nominal dollars, whereas reports of recent negative GDP growth refer to real, inflation adjusted dollars.

This chart shows that while GDP rose fairly steadily since 1980, the DOW earnings growth significantly lagged the GDP growth from 1980 bottoming with the recession in 1992. Thereafter the DOW earnings rose at about the same rate as GDP or a bit higher before plunging after 2007. A best fit trend line since 1980 would likely place the 2009 DOW earnings as low as about $500 (which with a P/E of 15 would put the fair value of the DOW at (gulp) 7,500 and even with an 18 P/E it would only be 9,000). A best fit DOW earnings trend line since 1992 would place the 2009 DOW earnings at about $700 (implying at a 15 P/E a fair value DOW of 10,500 or at and 18 P/E, a fair value DOW of 12,600.)

The high DOW earnings in 2007 were clearly above the trend line.

Our representative normalized earnings value of $663 being the trailing earnings with negatives removed is between our low and high estimates of $500 to $700 and closer to the high end. This shows that our normalized stating earnings level of $663 is not overly optimistic, nor overly pessimistic, but appears to be a reasonable although perhaps moderately optimistic estimate.

The Dow Jones Industrial Average represents a portfolio of 30 stocks. For each $10,471 (the index value)   purchased, the underlying companies in the portfolio therefore, on a representative or normalized basis, earned  $663 in the past reported four quarters and currently pays a dividend of $10,471 * 0.0261 = $294 per year. 

When we buy the Dow Jones Industrial Average index, we can therefore think of it as being an investment or "stock" that (as of December 13, 2009) costs $10,471 and currently earns $663 per year and pays a dividend of $294 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $10,471.

We know that the Dow Jones Industrial Average index was at 10,471 on December 13, 2009. We can estimate what the DJIA "should" have been trading at based on the value of its current earnings and dividends and the projected growth in those earnings and dividends. This intrinsic value approach calculates the present value of the projected earnings and dividends for a ten year period and assuming that the index is sold at a projected future P/E.

In addition to the beginning earnings and dividend level, three additional factors are required to calculate the fair value at which the DJIA should be trading at. These are, 1. The forecast average annual growth rate in earnings and dividends over the next (say) ten years. 2. The forecast P/E ratio at which the DJIA index will be trading in ten years time (an assumed ten year holding period for analysis purposes). 3. The estimated minimum expected rate of return required by investors. (This required return is used to discount values to today's present value).

Warren Buffett has argued that over the longer term, the Dow Jones Industrial Average portfolio average earnings should grow at a rate close to the growth rate of the U.S. economy in nominal (after inflation) terms. I believe a prudent estimate for this growth rate is  normally 4% to 6% and I would normally focus on 5%. This 5% can also be thought of as 3% real GDP growth and 2% for inflation).  Currently there is a lot of uncertainty as to both expected real GDP  growth and the inflation level. Some expect deflation while others expect inflations. Overall a 5% earnings growth assumption does not seem unreasonable but is certainly subject to much uncertainty..

The average P/E for the Dow Jones Industrial average since 1929 has been 15.5 (Uses year-end data and excludes years when the P/E was abnormally high due to near-zero earnings and not due to optimism (1933 P/E 47.3, 1982 P/E 114.4, and 1991 P/E 64.3 are all excluded as outliers). However the Justifiable P/E changes with earnings expectations and the market's required return on equities. I have conservatively calculated that the current Justifiable P/E is in the range of only 12.5 to 14.3, even with today's low interest rates.  This conservative calculation of the justifiable P/E assumes that, on average, the DOW companies will only earn, on new investments,  the 7 to 8% minimum ROEs required by investors in today's low-interest rate environment.  The more optimistic we are about the level of the P/E in ten years time, the higher is the justifiable fair value level of the DJIA index today. Possibly proprietary technology, scale advantages and brand loyalty may allow corporations to earn ROEs somewhat above the minimum required by investors and this would justify somewhat higher P/E ratios.

When I first calculated, in 2002,  that the sustainable P/E ratio for a broad stock index was about 12.5  to 14.3 the figure seemed impossibly low given that the market index P/Es were well over 20 at that time. But given that the Dow Jones Industrial Average at the end of 2008 was 13.3 times  trailing earnings, my earlier calculation of the sustainable P/E now looks quite plausible indeed.

I would estimate that a minimum (pre-tax) return required by stock investors, on a broad portfolio of stocks, is in the range of no more than 7% to 9%. The higher return required by investors then the lower the price or level that investors should be willing to pay for the index today, all else being equal.

The following table calculates the value that the Dow Jones Industrial Average  will be at in ten years given various forecasts for the earnings growth and given various scenarios for the forecast P/E ratio that will apply at that time. The last column of the table then shows the fair or present value  that we should be willing to pay today for the cash flows that would result from receiving each of the ten years of dividends plus the assumed cash from selling the index in ten years time (at the amount in the column titled "Resulting DJIA in 10 years"). The cash flows are converted to a "present value" calculated using the amount in the "Required Return" column. The present value is calculated based on various scenarios (as shown) for the required return or discount rate applied to each earnings growth and ending P/E scenario.

DJIA Forecast Current Annual Earnings

DJIA Current  Annual Dividends

Earnings and Dividend Growth forecast

DJIA P/E forecast in 10 years

Resulting DJIA in 10 years (Year 2018)

Required Return

Resulting DJIA Fair Value Today

663	273	4%	13	12,758	7%	8,828
663	273	4%	15	14,721	7%	9,826
663	273	4%	17	16,684	7%	10,824
663	273	4%	13	12,758	9%	7,517
663	273	4%	15	14,721	9%	8,346
663	273	4%	17	16,684	9%	9,175
663	273	5%	13	14,039	7%	9,601
663	273	5%	15	16,199	7%	10,699
663	273	5%	17	18,359	7%	11,797
663	273	5%	13	14,039	9%	8,166
663	273	5%	15	16,199	9%	9,078
663	273	5%	17	18,359	9%	9,991
663	273	6%	13	15,435	7%	10,440
663	273	6%	15	17,810	7%	11,647
663	273	6%	17	20,185	7%	12,854
663	273	6%	13	15,435	9%	8,869
663	273	6%	15	17,810	9%	9,872
663	273	6%	17	20,185	9%	10,875

Conclusions

By changing the expected earnings growth rate, the return required by the investor and the assumed P/E ratio that will apply in ten years I can calculate that today's DJIA index should be anywhere from  7517  to 12,685. A reasonable scenario may be the highlighted row with 5% earnings growth per year, a 7% required rate of return and a final P/E ratio of 15 in ten years and a fair DOW level of 10,699. However, other scenarios are certainly plausible as well.

(Note however that all estimates assume $663 as the current representative normalized earnings on the DOW. If that number is too high then our results are optimistic and vice versa).

Since the Dow Jones Industrial Average is currently  about 10,471, I conclude that it is likely about fairly valued. (The point estimate of this would be 2% under-valued, although the calculation should not be considered to be at all precise).

The table illustrates quite a wide range for a reasonable fair value of the DJIA. 

Most investors would probably not admit to being happy with a 7% expected long-term return from stocks, but is arguably quite attractive compared to a current 10 year U.S. government bond yield of about 3.5%.  By that measure, even an expected 6% nominal return from stocks looks attractive compared to the 10-year bond yield.

Note also that the Price to book ratio of the Dow Jones Industrial Average is 2.81 which seems unattractively high. The DJIA companies have achieved a return on ending equity of about 17% in the past 12 months ROE = P/B/(P/E) and this may be very difficult to sustain. This suggests that earnings on the DOW stocks could decline to return the ROE to a more sustainable level.

The overall conclusion is that at its current level (as of December 13, 2009) of 10,471 the Dow Jones Industrial Average is about fairly valued.

It is impossible to predict where the DJIA will go in the next year. But it is relatively easy to calculate whether or not it is currently significantly under- or over-valued based on reasonable growth expectations and a reasonable projection for the P/E ratio and a reasonable assessment of investor's minimum required rate of return. Caution is warranted because the DJIA can sometimes spend years in an over-valued or an under-valued-state. But ultimately, as we saw in the early 2000's, and in 2008 valuation does correct itself.

Readers can also see our similar analysis of the S&P 500 index and of the Toronto Stock Exchange Index

Shawn C. Allen, CFA, CMA, MBA, P.Eng.

President,  InvestorsFriend inc. 

Last updated December 13, 2009

This is an update of an analysis I first did of the DJIA dated February 8, 2002

As of December 13, 2009, the DOW has significantly under performed compared to what was expected in early 2002. The good news is that a period of under-performance will ultimately at some point be followed by a period of over-performance.

Keep in mind that with the past analysis we also provided a range of valuations and readers were free to select a different fair valuation from our table above.

Date	DJIA Level	Fair Value we Calculated	Apparent Performance as of October 2009 with Index at 10,471
October 11, 2009	9,865	11,026	It's very early going but the DJIA has moved in the indicated direction (higher)
April 4, 2009	8,018	9,146	It appears we were correct, the index was under-valued on April 4, 2009
Dec 6, 2008	8,635	10,317	It now appears we were moderately optimistic. Earnings were at $752 based on an average of GAAP and operating and have not grown.
Nov 6, 2008	8,696	10,506	It now appears we were moderately optimistic. Earnings were at $690 and have not grown.
June 8, 2008	12,182	12,931	We now appear too optimistic as the $803 earnings from June 2008 have declined instead of grown. In hindsight, we should have considered whether earnings were above the trend line. The trend line was not part of the analysis at that time.
Sep 8, 2007	13,113	13,214	We were too optimistic as we did not project a sharp earnings decline.
Sept 15, 2006	12,446	12,009	We were too optimistic,  the earnings, then at $720 did not grow as expected.
May 31, 2005	10,467	10,912	We were too optimistic,  the earnings, then at $661 did not grow as expected.
Nov 30, 2004	10,428	10,716	We were too optimistic,  the earnings did not grow as expected.
Feb 8, 2002	9744	9,820	In hind-sight we were way too optimistic. Earnings, then at $485 did not grow at the then expected 7% and our assumed terminal P/E at 18 now seems too high. But we did recognize that our fair value of 9,820 in 2002 might be too high and we stated at that time: Investors should be sobered by the fact that if investors require a 9% rate of return and if the earnings only grow at 5% (say 3% GDP plus 2% inflation) and if the DOW commands a P/E of only 15 in ten years then the fair value of the DOW is calculated as only 5898. So conservative but not really gloomy forecasts of earnings, required return level, and P/E result in a fair value of the DOW at only 5898. Gulp!

 

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