IS THE DOW JONES INDUSTRIAL AVERAGE (“DJIA”) INDEX OVERVALUED?
(This article is dated February, 2002, for a current version, click here)
As of February 8, 2002, the DJIA index was at 9744 and had a Price Earnings Ratio (“P/E”) of 25.17 and a Dividend yield of 1.12%. (Source: DJI Indexes)
The DJIA represents a portfolio of 30 stocks. For each $9744 (the index value) purchased the underlying companies in the portfolio are therefore currently earning $9744/25.17 = $387 per year and paying a dividend of $9744 * 0.0112 = $109 per year.
We know that the DJIA index is at 9744. We can estimate what the DJIA should be trading at based on the value of the earnings and dividends. My model calculates the value of the earnings and dividends for a ten year period and then assumes that the index is sold at a projected future P/E.
It appears that the current DOW earnings are depressed by recession and therefore are not representative of normal conditions. Therefore I will use the actual year 2000 DOW earnings of $485 as my starting adjusted earnings level. This is based on a belief that the DOW companies should return to pre-recession earnings levels and then grow from there. The Dividend level too appears depressed but that may be due to changes in the DOW component stocks and so I will use the current dividends. Dividends normally would not decline much during a recession.
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 compound growth rate in earnings and dividends over the next ten years. 2. The forecast P/E ratio at which the DJIA index will be trading in ten years time. 3. The estimated rate of return required by investors.
The DJIA 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 5% to 7%.
The average P/E for the Dow Jones Industrial average since 1950 is 18 and I believe that 15 to 20 represents a prudent forecast for the P/E at which the DJIA index will be trading in 10 years. 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.
As o February 8, 2002, U.S. investors can get a risk-free return of 4.9% (10 year U.S. Treasury Bond yield) . An investor in the stock market will require a risk premium and I would estimate that a minimum return required by stock investors is in the range of 7% to 9%. The higher return required by investors then the lower the price that investors must pay for the index today, all else being equal.
The following table calculates the value that the DJIA should be trading at given prudent assumptions about earnings growth, the P/E ratio that will exist in ten years and the rate of return that investors require.
| DJIA Current Annual Earnings | DJIA Annual Dividends | Earnings and Dividend Growth forecast | P/E forecast in 10 years | Resulting DJIA in 10 years | Required Return | Resulting DJIA Fair Value Today |
| $485 | $109 | 5% | 15 | 11,850 | 7% | 7,008 |
| $485 | 109 | 5% | 18 | 14,220 | 7% | 8,213 |
| $485 | 109 | 5% | 20 | 15,800 | 7% | 9,016 |
| $485 | 109 | 5% | 15 | 11,850 | 9% | 5,898 |
| $485 | 109 | 5% | 18 | 14,220 | 9% | 6,899 |
| $485 | 109 | 5% | 20 | 15,800 | 9% | 7,567 |
| $485 | 109 | 7% | 15 | 14,311 | 7% | 8,365 |
| $485 | 109 | 7% | 18 | 17,173 | 7% | 9,820 |
| $485 | 109 | 7% | 20 | 19,081 | 7% | 10,790 |
| $485 | 109 | 7% | 15 | 14,311 | 9% | 7,031 |
| $485 | 109 | 7% | 18 | 17,173 | 9% | 8,240 |
| $485 | 109 | 7% | 20 | 19,081 | 9% | 9,046 |
| $485 | 109 | 9% | 15 | 17,223 | 7% | 9,964 |
| $485 | 109 | 9% | 18 | 20,667 | 7% | 11,715 |
| $485 | 109 | 9% | 20 | 22,963 | 7% | 12,882 |
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 5,900 to 12,900.
My own best estimate is high-lighted in yellow and is 9,820.
Since the DJIA is (somewhat coincidentally) currently 9744, I conclude that it is likely about fairly valued.
The table illustrates quite a wide range for a reasonable fair value of the DOW. 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!
On the other hand many people may believe that the DOW should be closer to 12,000 since it has already been over 11,000. In order to justify a 12,882 level we have to assume that investors require only a 7% return, that the earnings will grow at a robust 7% and that the P/E will be at 20 in ten years which is above the long term average of 18. I consider that to be a rather optimistic scenario.
Overall, I conclude that my highlighted estimate of 9820 is a fair value, though it probably leans more to the optimistic side since it requires: a 7% growth rate, that investors require only a 7% return and that the P/E will revert to the average of 18.
My conclusion is that at its current level of 9744, the DOW is neither dangerously high nor is particularly cheap. Long term investors should certainly not abandon the market but might want to avoid being 100% in equities.
Shawn Allen,
Editor
February 8, 2002
UPDATE, 10 YEARS LATER
10 years have now passed since this article was written. On February 8, 2012 the Dow Jones Industrial Average stood at 12,884. As shown in the yellow highlighted row in the table above, my best estimate in February 2002 was that in February 2012 the DOW would be at 17,173. That was based on earnings growing 7% per year from $485 to $954 and a P/E of 18 applying.
Well, it turns out that the earnings on the DOW for 2011 on a normalized basis were about $967. So, my growth estimate of 7% per year was quite accurate.
But it was the P/E ratio that I got wrong. I had used a historical average P/E of 18. However, I later realized that the true historical average after removing a few very high P/Es in the historical data (due to abnormally low earnings) was actually closer to 15. At a P/E of 15 and a growth rate of 7%, the above table predicted a DOW level in February 2012 of 14,311. That is only 10% higher than its actual level turned out to be.
In any event I would not expect the prediction to be very accurate given all the variables. The bottom line is that I concluded in 2002 that the DOW was at a fair value. In fact it turns out that it gained 3.0% per year and there was also the dividend of about 2%, for a total return of about 5%. In fact, Dow Jones reports that the DOW returned a total of 5.1% per year in the ten years ending February 2012. So in reality it turns out that the DOW was somewhat over-valued in February 2002, assuming that the 12,978 level of February 2012 is a “fair” level. Still, an investment in the DOW at February 2002 has returned 5% per year and that is not so very bad.
March 3, 2012