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IS
THE DOW JONES INDUSTRIAL AVERAGE ("DJIA") INDEX A GOOD INVESTMENT NOW
OR IS IT OVER-VALUED? (At
June 8, 2008)
A quick indication of whether or not the Dow Jones
Industrial Average is fairly valued is to look at the P/E ratio. At this time
P/E ratio on the DJIA index is about 15.2. This is neither particularly high nor
particularly low. Therefore the quick indication is that the DJIA index is about
fairly valued at this time.
This article explores the question in much more detail
below.
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 long-term indicator of the expected return from investing in
the DJIA at this time.
The DJIA valuation question can be more fully answered by looking at the current
level of earnings and dividends of the DJIA stocks, forecasting a reasonable future rate
of earnings and dividend growth and by considering the minimum return required
by investors. Analysts often apply valuation techniques 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 most
of the random noise of unexpected events through diversification. An index
remains vulnerable to changes in interest rates and to uncertain growth in the economy but is largely insulated
from the numerous random events that can impact an individual stock.
As of June 8, 2008, the Dow Jones Industrial Average index was at
12,182 and had a
Price Earnings Ratio ("P/E") of 15.2 based on trailing earnings and
12.8 based on projected earnings and had a Dividend yield of 2.68%.
(Source:
http://www.djindexes.com/jsp/avgStatistics.jsp ) Many analysts use projected earnings. Since projected earnings
can be optimistic, to be more conservative, I
prefer to focus on simply the trailing P/E which is
15.2 from which I can calculate the actual reported earnings of the DOW over the past
12 months. (Most of the earnings would be for the 12 months ended March 31,
2008).
It is interesting to note that the ratio of the actual to
the projected P/E indicates that analysts are projecting that the 30 huge DJIA
companies will increase their earnings by an average of 15.2/12.8-1 = 18.7%. I
think that kind of growth projection is far too optimistic after years of strong
earnings growth and in light of a probable U.S. recession. In the past in this
calculation I have given some weight to the projected P/E but at this time I
have decided to strictly use the actual P/E based on achieved earnings and not
projected earnings, as my starting point.
The Dow Jones Industrial Average represents a portfolio of 30 stocks. For each
$12,182 (the index value) purchased, the underlying companies in the portfolio
therefore
actually earned $12,182/15.2 = $817 in the past reported 12 months and
currently paid a dividend of $12,182 * 0.0268 = $327
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 June 8, 2008) costs $12,182 and
currently earns $817 per year and pays a dividend of $327 per year. It is worth thinking
about whether or not this "stock" is a good investment at or around its recent
level of $12,182.
We know that the Dow Jones Industrial Average index was at 12,182 on
June 8, 2008. 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 4% to 6% and I would
focus on 5%. This 5% earnings growth assumption is lower than recent experience
but is consistent with experience in the past when inflation was low. This 5%
can also be thought of as 3% real GDP growth and 2% for inflation).
The average P/E for the Dow Jones Industrial average since
1950 has been 16.6 (Uses year-end data and excludes 1982 when the P/E was over 100 due
to near-zero earnings presumably due to some unusual large losses). 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.
When I first calculated 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
15.2 times trailing earnings and 12.8 times projected
earnings, my calculation is starting to look quite reasonable.
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
ten years of dividends plus the assumed cash from selling the index in ten years
time. The present value is calculated based on various scenarios for the
required return or discount rate.
|
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 |
|
803 |
327 |
4% |
14 |
16,647 |
7% |
11,270 |
|
803 |
327 |
4% |
15 |
17,836 |
7% |
11,875 |
|
803 |
327 |
4% |
16 |
19,025 |
7% |
12,479 |
|
803 |
327 |
4% |
14 |
16,647 |
9% |
9,582 |
|
803 |
327 |
4% |
15 |
17,836 |
9% |
10,085 |
|
803 |
327 |
4% |
16 |
19,025 |
9% |
10,587 |
|
803 |
327 |
5% |
14 |
18,319 |
7% |
12,266 |
|
803 |
327 |
5% |
15 |
19,627 |
7% |
12,931 |
|
803 |
327 |
5% |
16 |
20,936 |
7% |
13,597 |
|
803 |
327 |
5% |
14 |
18,319 |
9% |
10,417 |
|
803 |
327 |
5% |
15 |
19,627 |
9% |
10,970 |
|
803 |
327 |
5% |
16 |
20,936 |
9% |
11,523 |
|
803 |
327 |
6% |
14 |
20,140 |
7% |
13,347 |
|
803 |
327 |
6% |
15 |
21,579 |
7% |
14,078 |
|
803 |
327 |
6% |
16 |
23,017 |
7% |
14,809 |
|
803 |
327 |
6% |
14 |
20,140 |
9% |
11,323 |
|
803 |
327 |
6% |
15 |
21,579 |
9% |
11,931 |
|
803 |
327 |
6% |
16 |
23,017 |
9% |
12,538 |
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 (a scary) 9,582 to 14,809 My own fair-value estimate is high-lighted in yellow and is
12,931. This assumes that investors require a
minimum 7% return, that the DJIA
earnings and dividend will grow at 5% per year (3% GDP growth plus 2% inflation) and that the
long run DJIA P/E is 15. My
projected P/E of 15 gives some weight to the DOW's long run average of 16.6 and
some weight to my conservative justifiable P/E estimate of 12.5 to 14.3. It also
happens to closely match the recent actual trailing P/E on the DJIA. Higher DJIA
index values are implicitly assuming that earnings growth will exceed 5%
annually, that the justifiable long-run DJIA P/E exceeds 16, and/or that investors
require less than a 7% (pre-personal income tax) return.
Since the Dow Jones Industrial Average is currently
about 12,210, I conclude that it is likely moderately under- valued. (I
note that if I change my terminal P/E assumption to 14 then my fair value
estimate for the DJIA falls to 12,266 which would indicate the DJIA is fairly
valued today)
An assumption that the DJIA earnings growth will only
average 5% may seem low given the growth achieved in recent years. But remember
that we may be heading into a recession and that the high earnings growth of
recent years may make it much more difficult to grow from such a high base.
The table illustrates quite a wide range for a reasonable
fair value of the DJIA. 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 DJIA commands a P/E of only 14 in ten years then the
fair value of the DJIA today is calculated as only 9,582, which is 21% below the current
value of 12,210!
Most investors would probably not admit to being happy with a
7% return, but the level of the DOW today suggests that investors have bid stocks up
to the point where about 7% is a realistic long-term return. Also 7% is
quite attractive compared to a current 10 year U.S. government bond yield of about
3.7%. By that measure, even an expected 6% nominal return from stocks
looks attractive compared to the 10-year bond yield.
If we expect the DJIA P/E to remain around 15.2 then the
amount we we should expect to earn by investing in the DJIA index is equal to
our earnings growth assumption plus the dividend yield. Thus with a 5% earnings
growth assumption, plus 2.68% for dividends we could expect to earn about 7.7%
per year. Any decrease in the P/E would take away from this return. The P/E
could decrease if the market believed that earnings growth would slow to the 5%
level and/or if longer-term interest rates rise significantly.
Note also that the Price to book ratio of the Dow Jones Industrial Average is 3.4
which seems unattractively high. Mathematically, this indicates that the DJIA
companies have achieved a return on ending equity of 3.4/15.2 = 22%, 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..
My overall conclusion is that at its current level (as
of June 8, 2008) of
about 12,182 the Dow Jones Industrial Average
is probably about fairly valued or slightly under-valued and priced to return
an average of about 7% (as a mid-point estimate)
per year based on a 10 year holding period. (However, if long-term interest rates were to rise sharply then the
P/E ratio would fall as would earnings and if we believe in that scenario, then
the DJIA is over-valued). Even if this average 7% per year turns out to
be correct, there will be huge volatility around the 7% average in any
given year.
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 a similar
analysis of the S&P 500
index which paints a roughly similar picture, but slightly more pessimistic
outlook for that broader index.
Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend inc.
Last updated June 8, 2008
This is an update of an analysis I first did of the
DJIA dated February 8, 2002At
that time the DJIA was at 9744 and was judged a fair level if investors required a 7%
return, earnings growth would average 7% and the P/E would decline from its then
25 level down to 18. In reality what happened is that the P/E has fallen further
than expected all the way to 15 while earnings grew at a faster-than-expected
rate of 9.1%. DJIA investors since February 2002 have earned an average (but
extremely lumpy) 5.6% per year consisting of an average 3.8% per year in capital
gains plus perhaps 1.8% per year in dividends (The dividend yield in 2002 was
only 1.12% but has since risen to 2.68%). In retrospect our assessment that
9,744 was a fair value for the DJIA in early 2002 was a reasonably correct
although I underestimated how far the P/E would fall. (This under-estimation was
partly because at the time I had calculated the historic average DJIA P/E at 18
rather than the 16.6 that I now use). I believe that the results of the 2002
analysis are well validated by the actual result six years later.
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