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

This page (which draws on Warren Buffett's teachings¹) provides:

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

2. Expected next 10-year average Return per Year from the Dow Jones industrial Average based on earnings growth and ending P/E Assumptions

3. The expected next 10-year average Return per Year from the Dow Jones Industrial Average based on growth calculated from the ROE and assuming a constant P/E.

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

5. Dividend Yield on the Dow Jones Industrial Average

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

7. 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 (only) on four things: i) the return that investors require, ii) the current earnings and dividend level, iii) the expected growth rate in earnings and dividends, and iv) the  expected 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. 

This analysis is dated September 10, 2011. 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  estimates 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  12.3. This is attractively low compared to the historical average of 15.5. Therefore the quick indication is that the DJIA index is somewhat under valued as at September 10, 2011 at 10,992.

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 average annual 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, making a reasonable forecast of the 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? (September 10, 2011 with the index at 10,992)

Data from the Dow Jones company are as follows:

DJIA Earnings Type	Annual Earnings on Dow Industrials	P/E Ratio at 10,992 DOW	Earnings Yield (1/P/E)
Actual latest year (trailing four quarters) GAAP earnings	$897	12.3	8.16%
Latest year operating  earnings (removes negative earnings)	$914	12.0	8.32%
Forecast forward GAAP earnings for the next year (next four quarters)	$1061	10.4	9.65%
Forecast forward operating earnings for the next year (removes negative earnings)	$1061	10.4	9.65%
For Comparison here are the DJIA earnings in prior years:		Historical GAAP P/E	Historical Earnings Yield
2010 Actual GAAP Earnings	$831	13.9	7.18%
2009 Actual GAAP Earnings	$624	16.7	5.99%
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 reasonably "representative" of "normal" expected economic conditions and has not been materially affected upwards or downwards by usual items.

In our view a fair estimate of the "representative" earnings level on the DJIA in the past year is the trailing earnings of $897. 

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. Note also, that the right and left hand scales are consistent, both rise 10,000 fold.

The above chart shows that the annual earnings on the DOW have trended 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 Dow earnings (the red line) had dipped noticeably after reaching a peak in 2007 but has made a full recovery as of now. The GDP figure shows a dip in 2009 which was more than fully recovered in 2010. Note that the GDP figures here are in nominal dollars, to be consistent with the earnings on the Dow, whereas most reports of  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 and then fully recovering by 2010. 

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

The Dow Jones Industrial Average represents a portfolio of 30 stocks. For each $10,992 (the index value)   purchased, the underlying companies in the portfolio therefore, on a trailing earnings which we also consider to be a reasonable representative or normalized basis, earned  $897 in the past reported four quarters and currently pays a dividend of $10,992 * 0.0292 = $321 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 September 10, 2011) costs $10,992 and currently earns $897 per year and pays a dividend of $321 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $10,992.

We know that the Dow Jones Industrial Average index was at 10,992 on September 10, 2011. 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 (not adjusted down to remove 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, which lowers our historical P/E estimate). 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 assuming that investors will be satisfied with a projected return of 7% or 8% respectively due to 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. Quite possibly proprietary technology, scale advantages and brand loyalty may allow corporations to earn, even on new investments, 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 or justifiable 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 today is just 12.3 times  trailing earnings, my earlier calculation of the sustainable or justifiable 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 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.

 

Earn	Div	Growth	Terminal P/E	Resulting DJIA in 10 years	Required Return	DJIA Fair Value Today	Implied Fair P/E today	Return per Year Buying at 10992
897	321	4%	13	17,261	7%	11,529	12.9	7.6%
897	321	4%	15	19,917	7%	12,879	14.4	8.9%
897	321	4%	17	22,572	7%	14,229	15.9	10.1%
897	321	4%	13	17,261	9%	9,793	10.9	7.6%
897	321	4%	15	19,917	9%	10,915	12.2	8.9%
897	321	4%	17	22,572	9%	12,037	13.4	10.1%
897	321	5%	13	18,995	7%	12,554	14.0	8.6%
897	321	5%	15	21,917	7%	14,039	15.7	10.0%
897	321	5%	17	24,839	7%	15,525	17.3	11.2%
897	321	5%	13	18,995	9%	10,652	11.9	8.6%
897	321	5%	15	21,917	9%	11,886	13.3	10.0%
897	321	5%	17	24,839	9%	13,121	14.6	11.2%
897	321	6%	13	20,883	7%	13,665	15.2	9.6%
897	321	6%	15	24,096	7%	15,299	17.1	11.0%
897	321	6%	17	27,309	7%	16,932	18.9	12.2%
897	321	6%	13	20,883	9%	11,583	12.9	9.6%
897	321	6%	15	24,096	9%	12,940	14.4	11.0%
897	321	6%	17	27,309	9%	14,298	15.9	12.2%

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  9,793  (we would earn an average 7.6% per year under these assumptions) to 16,932 (we would expect to earn an average 12.2% per year under those assumptions). A reasonable scenario may be average of the two highlighted rows with 5% earnings growth per year, a 8% (average of 7% and 9% in the two rows) required rate of return and a final P/E ratio of 15 in ten years and a fair DOW level of 12,963 and an expected return of 10.0% per year on average. However, other scenarios are certainly plausible as well.

Note however that all estimates assume $897 as the current representative normalized earnings on the DOW. The forward earnings estimate suggests we will be at $1060 for the next year and if that is true my valuation is on the conservative side. Given the strong recent earnings growth, and the soft economy the forward earnings that suggest earnings will grow 18% seems optimistic.

Since the Dow Jones Industrial Average is currently  about 10,992, I conclude that it is likely about under valued. The estimate based on this analysis is that it is about 15% under-valued.

The table illustrates quite a wide range for a reasonable fair value of the Dow Jones Industrial Average. 

Many investors might not admit to being happy with an  8% expected long-term return from stocks, but 8% seems highly attractive compared to a current 10 year U.S. government bond yield of about 2.0%.  

Note also that the Price to book ratio of the Dow Jones Industrial Average is 2.38. The DJIA companies have therefore achieved a return on ending equity of about 19.4% in the past year based on ROE = P/B divided by P/E.

Another way to calculate the expected return on the Dow Jones Industrial Average index is by using the dividend growth model. This assumes that the dividend will grow at the rate of the ROE on retained earnings times the proportion of earnings that are retained.  The dividend payout ratio calculated from the dividend and earnings in the table above is 321/897 = 36%. That means the earnings retention ratio is 64%. If the DJIA companies could continue to make the same ROE of 19.4% on their existing equity plus on retained earnings then the dividend would grow at 64% of that or 12.4%. Adding the current dividend yield of 2.9% would then suggest an expected return of about 15.3%. However, an 19.4% ROE on future as well as past retained earnings seems far too optimistic. If we use a 10% ROE on new investments (of future retained earnings) the expected return on this basis is about 9% (6.4% plus 2.9%). And this assumes that the P/E remains constant at 12.3. 

The overall conclusion is that at its current level (as of September 10, 2011) of 10,992 the Dow Jones Industrial Average is about 15% 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 significantly under- or over-valued based on reasonable growth expectations and a reasonable projection for the P/E ratio and a reasonable assessment of investors' 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.

You can easily invest in the Dow Jones Industrial Average Index index by buying the SPDR Dow Jones Industrial Average index Exchange Traded Fund under the symbol DIA on the New York Stock Exchange.

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 September 10, 2011 (ETF symbol added November 23, 2011)

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

The table below shows how this analysis has performed in the past. The results are mixed. Our fair value of the DOW estimates in the earlier years were too optimistic. In recent years it appears to be working better perhaps due to enhancements to the calculations and better considerations of whether the beginning earnings needed to be normalised or not.

Date of Prior Calculations	DJIA Level	Fair Value we Calculated	Average Capital Gain Per Year	Apparent Performance as of September 10, 2011 with Index at 10,992
March 6, 2011	12170	11997	-17.9%	the DJIA has moved in the indicated direction (lower)
September 11, 2010	10,463	11779	5.1%	the DJIA has moved in the indicated direction (higher)
May 29, 2010	10,137	10,975	6.5%	the DJIA has moved in the indicated direction (higher)
October 11, 2009	9,865	11,026	5.8%	the DJIA has moved in the indicated direction (higher)
April 4, 2009	8,018	9,146	13.8%	It appears we were correct, the index was under-valued on April 4, 2009
December 6, 2008	8,635	10,317	9.1%	It appears we were directionally correct
November 6, 2008	8,696	10,506	8.6%	It appears we were directionally correct
June 8, 2008	12,182	12,931	-3.1%	We now appear too optimistic as the $803 earnings from June 2008 declined before finally recovering. 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.
September 8, 2007	13,113	13,214	-4.3%	We were too optimistic as we did not project a sharp earnings decline.
September 15, 2006	12,446	12,009	-2.5%	We were too optimistic,  the earnings, then at $720 did not grow as expected.
May 31, 2005	10,467	10,912	0.8%	We were too optimistic,  the earnings, then at $661 did not grow as expected.
November 30, 2004	10,428	10,716	0.8%	We were too optimistic,  the earnings did not grow as expected.
February 8, 2002	9,744	9,820	1.3%	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 way 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!

 

 

1. See Warren Buffett in Fortune Magazine, November 22, 1999, and  his updated article of December 10, 2001.