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WHAT IS THE FAIR VALUE OF
THE DOW JONES INDUSTRIAL AVERAGE ("DJIA")?
This page provides:
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The Dow Jones Industrial Average P/E ratio (based
on trailing and forward earnings)
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Earnings on the Dow Jones Industrial Average (GAAP,
operating and forward earnings)
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Dividend Yield on the Dow Jones Industrial Average
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A link to the P/E , earnings and dividend information on
the the Dow Jones web site
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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 |
|
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| 2005 Actual GAAP Earnings |
$476 |
|
|
| 2004 Actual GAAP Earnings |
$592 |
|
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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.
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