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WHAT IS THE FAIR VALUE OF THE DOW JONES INDUSTRIAL AVERAGE ("DJIA")?
This page provides:
The Dow Jones Industrial Average P/E ratio (based on trailing and forward earnings)
Earnings on the Dow Jones Industrial Average (GAAP, operating and forward earnings)
Dividend Yield on the Dow Jones Industrial Average
A link to the P/E , earnings and dividend information on the the Dow Jones web site
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 April 4, 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 June 2009 when the next set of quarterly earnings numbers becomes available for the DJIA.
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 15.0. This is neutral in attractiveness. Therefore the quick indication is that the DJIA index is fairly valued at this time at 8,018.
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? (April 4 with the index at 8,018)
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 8,018 DOW | Earnings Yield |
| Actual latest year (trailing four quarters) GAAP earnings | $535 | 15.0 | 6.67% |
| Latest year operating earnings (removes negative earnings) | $806 | 9.95 | 10.0% |
| Forecast forward GAAP earnings for the next year (next four quarters) | $450 | 17.8 | 5.62% |
| Forecast forward operating earnings for the next year (removes negative earnings) | $663 | 12.1 | 8.26% |
| For Comparison here are the DJIA earnings in prior years: | |||
| 2008 Actual GAAP Earnings | $661 | ||
| 2007 Actual GAAP Earnings | $831 | ||
| 2006 Actual GAAP Earnings | $720 | ||
| 2005 Actual GAAP Earnings | $476 | ||
| 2004 Actual GAAP Earnings | $592 |
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 been distorted downwards by extremely large and unusual loses at companies like General Motors, Bank of America and Citi Bank. On the other hand a few companies in the Dow linked to commodities have enjoyed unusually high earnings. In our view a fair and perhaps conservative estimate of the "representative" earnings level on the DJIA in the past year is to average the actual GAAP earnings figure and the figure that removes negative earnings to arrive at $670. This is well below the actual earnings of 2007 and moderately 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 $670 is 19% below the earnings from 2007 and 7% below the 2006 earnings and therefore it does not seem unrealistically high at all. Also it is 1% above the 2008 actual GAAP earnings which reflected a certain amount of unusual losses.
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
The last point on the chart is the earnings and GDP in the 12 months ended March 2009. The earnings have dipped noticeably since reaching a peak in 2007. The GDP figure is not yet showing a dip but is expected to show a flat spot or slight dip as updated data for GDP becomes available. Note that the GDP figures here are in nominal dollars, whereas reports of recent negative GDP growth refer to real, inflation adjusted dollars.
The last data point on the Chart shows that the actual Dow Jones Industrial Average earnings for the past 12 months ending March 31, 2009 at $661 are roughly on the trend line while the high earnings in 2007 were above the trend line. Our representative normalized earnings value of $670 being the average of the trailing GAAP earnings and the trailing earnings with negatives removed is probably close to the trend line. This shows that our normalized stating earnings level of $670 is not overly optimistic, nor overly pessimistic, but appears to be a reasonable estimate.
The Dow Jones Industrial Average represents a portfolio of 30 stocks. For each $8,018 (the index value) purchased, the underlying companies in the portfolio therefore, on a representative or normalized basis, earned $670 in the past reported four quarters and currently pays a dividend of $8,018 * 0.0336 = $269 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 April 4, 2009) costs $8,018 and currently earns $670 per year and pays a dividend of $269 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $8,018.
We know that the Dow Jones Industrial Average index was at 8,018 on April 4, 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). However, at the present time given the recession (which applies to perhaps the first year of our ten year projection) and given possible deflation, it ,may be more prudent to assume that the average growth in nominal GDP over the next ten years will be perhaps 4%. However, to some extent our normalized $670 initial earnings figure already accounts for the recession and therefore a 5% earnings growth assumption is also not unreasonable.
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 now, with the Dow Jones Industrial Average P/E at 15.0 times trailing earnings and 9.95 times trailing earnings that exclude negatives, my 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 |
| 670 | 269 | 4% | 13 | 12,893 | 7% | 8,862 |
| 670 | 269 | 4% | 15 | 14,876 | 7% | 9,871 |
| 670 | 269 | 4% | 17 | 16,860 | 7% | 10,879 |
| 670 | 269 | 4% | 13 | 12,893 | 9% | 7,543 |
| 670 | 269 | 4% | 15 | 14,876 | 9% | 8,381 |
| 670 | 269 | 4% | 17 | 16,860 | 9% | 9,219 |
| 670 | 269 | 5% | 13 | 14,188 | 7% | 9,641 |
| 670 | 269 | 5% | 15 | 16,370 | 7% | 10,750 |
| 670 | 269 | 5% | 17 | 18,553 | 7% | 11,860 |
| 670 | 269 | 5% | 13 | 14,188 | 9% | 8,196 |
| 670 | 269 | 5% | 15 | 16,370 | 9% | 9,118 |
| 670 | 269 | 5% | 17 | 18,553 | 9% | 10,040 |
| 670 | 269 | 6% | 13 | 15,598 | 7% | 10,485 |
| 670 | 269 | 6% | 15 | 17,998 | 7% | 11,705 |
| 670 | 269 | 6% | 17 | 20,398 | 7% | 12,925 |
| 670 | 269 | 6% | 13 | 15,598 | 9% | 8,904 |
| 670 | 269 | 6% | 15 | 17,998 | 9% | 9,917 |
| 670 | 269 | 6% | 17 | 20,398 | 9% | 10,931 |
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 7543 to 12,925. Rather than focus on just one scenario, I have highlighted a number of plausible scenarios. These scenarios have a range from 7543 (4% average nominal GDP growth, investors require an expected 9% return and terminal P/E at 13) to 10,750 (5% nominal GDP growth, investors require a 7% expected return and the terminal P/E is 15). The average of this range is 9,146.
(Note however that all estimates assume $670 as the current representative normalized earnings on the DOW. If that number is too high then our results are optimistic).
Since the Dow Jones Industrial Average is currently about 8,018, I conclude that it is likely under- valued. (The point estimate of this would be 12% under-valued, although the calculation should not be considered to be precise).
The table illustrates quite a wide range for a reasonable fair value of the DJIA. It is comforting to note that only 1 one of the scenarios in the table (4% growth, 9% required return and final P/E of 13) indicates a fair value of the DOW that is lower than the current level of 8,018
Most investors would probably not admit to being happy with a 7% return, but is arguably quite attractive compared to a current 10 year U.S. government bond yield that had recently dipped to the amazingly low level of about 2.7%. By that measure, even an expected 6% nominal return from stocks looks attractive compared to the 10-year bond yield. (Given that the DOW at 8,018 currently looks under valued, I would expect the actual return in the next ten years to be somewhat higher than 7%.)
Note also that the Price to book ratio of the Dow Jones Industrial Average is 3.51 which seems unattractively high. The DJIA companies have achieved a return on ending equity of just over 20% in 2008 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 April 4, 2009) of 8,018 the Dow Jones Industrial Average is moderately under-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 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, valuation does correct itself.
Readers can also see our similar analysis of the S&P 500 index
Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend inc.
Last updated April 4, 2009
This is an update of an analysis I first did of the DJIA dated February 8, 2002As of April 4, 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.