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WHAT IS THE FAIR VALUE OF THE DOW JONES INDUSTRIAL AVERAGE ("DJIA")?
This page (which draws on Warren Buffett's teachings1) 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.
This analysis is dated May 29, 2010. 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 15.2. This is about neutral in attractiveness. Therefore the quick indication is that the DJIA index is about fairly valued as May 29, 2010 at this time at 10,137.
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? (May 29, 2010 with the index at 10,137)
Data from the Dow Jones company (For this update I could not find the data but I have since found it at this link, the data below marked "not found" will be filled in for next update)
| DJIA Earnings Type | Annual Earnings on Dow Industrials | P/E Ratio at 10,137 DOW | Earnings Yield |
| Actual latest year (trailing four quarters) GAAP earnings | $667 | 15.2 | 6.58% |
| Latest year operating earnings (removes negative earnings) | not found | not found | not found |
| Forecast forward GAAP earnings for the next year (next four quarters) | not found | not found | not found |
| Forecast forward operating earnings for the next year (removes negative earnings) | not found | not found | not found |
| For Comparison here are the DJIA earnings in prior years: | Historical GAAP P/E | Historical Earnings Yield | |
| 2009 Actual GAAP Earnings | not found | not found | not found |
| 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.
In our view a fair and perhaps conservative estimate of the "representative" earnings level on the DJIA in the past year is the trailing earnings of $667. 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 $667 is about 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.
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 $667 being the trailing earnings with 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 $667 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 $10,137 (the index value) purchased, the underlying companies in the portfolio therefore, on a representative or normalized basis, earned $667 in the past reported four quarters and currently pays a dividend of $10,137 * 0.0294 = $298 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 May 29, 2010) costs $10,137 and currently earns $667 per year and pays a dividend of $298 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $10,137.
We know that the Dow Jones Industrial Average index was at 10,137 on May 29, 2010. 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.
| Earn | Div | Growth | Terminal P/E | Resulting DJIA in 10 years | Return | DJIA Fair Value Today | Implied Fair P/E today |
| 667 | 298 | 4% | 13 | 12,835 | 7% | 9,082 | 13.6 |
| 667 | 298 | 4% | 15 | 14,810 | 7% | 10,086 | 15.1 |
| 667 | 298 | 4% | 17 | 16,784 | 7% | 11,089 | 16.6 |
| 667 | 298 | 4% | 13 | 12,835 | 9% | 7,744 | 11.6 |
| 667 | 298 | 4% | 15 | 14,810 | 9% | 8,579 | 12.9 |
| 667 | 298 | 4% | 17 | 16,784 | 9% | 9,413 | 14.1 |
| 667 | 298 | 5% | 13 | 14,124 | 7% | 9,870 | 14.8 |
| 667 | 298 | 5% | 15 | 16,297 | 7% | 10,975 | 16.5 |
| 667 | 298 | 5% | 17 | 18,470 | 7% | 12,079 | 18.1 |
| 667 | 298 | 5% | 13 | 14,124 | 9% | 8,406 | 12.6 |
| 667 | 298 | 5% | 15 | 16,297 | 9% | 9,324 | 14.0 |
| 667 | 298 | 5% | 17 | 18,470 | 9% | 10,242 | 15.4 |
| 667 | 298 | 6% | 13 | 15,528 | 7% | 10,725 | 16.1 |
| 667 | 298 | 6% | 15 | 17,917 | 7% | 11,939 | 17.9 |
| 667 | 298 | 6% | 17 | 20,306 | 7% | 13,154 | 19.7 |
| 667 | 298 | 6% | 13 | 15,528 | 9% | 9,124 | 13.7 |
| 667 | 298 | 6% | 15 | 17,917 | 9% | 10,133 | 15.2 |
| 667 | 298 | 6% | 17 | 20,306 | 9% | 11,142 | 16.7 |
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 7,744 to 13,154. 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 10,975. However, other scenarios are certainly plausible as well.
(Note however that all estimates assume $667 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 10,137, I conclude that it is likely about fairly valued. (The point estimate of this would be 8% 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 3.3%. 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 (sorry, we could not find this figure at this time). The DJIA companies have achieved a return on ending equity of about XX% in the past 12 months ROE = P/B/(P/E).
The overall conclusion is that at its current level (as of May 29, 2010) of 10,137 the Dow Jones Industrial Average is about fairly valued to slightly 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 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 May 29, 2010
This is an update of an analysis I first did of the DJIA dated February 8, 2002As of May 29, 2010, 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 May 2010 with Index at 10,137 |
| 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 | |
| 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 | |
| May 31, 2005 | 10,467 | 10,912 |
|
| Nov 30, 2004 | 10,428 | 10,716 | We were too optimistic,
|
| 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! |
1. See Warren Buffett in Fortune Magazine, November 22, 1999, and his updated article of December 10, 2001.