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, 2002

At 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.