WHAT IS THE FAIR VALUE OF THE DOW JONES INDUSTRIAL AVERAGE ("DJIA")?
 

This page (which draws on Warren Buffett's teachings¹) provides:

1. The Dow Jones Industrial Average  P/E ratio (based on trailing and forward earnings)

2. Expected next 10-year average Return per Year from the Dow Jones industrial Average based on earnings growth and ending P/E Assumptions

3. The expected next 10-year average Return per Year from the Dow Jones Industrial Average based on growth calculated from the ROE and assuming a constant P/E.

4. Earnings on the Dow Jones Industrial Average (GAAP, operating and forward earnings)

5. Dividend Yield on the Dow Jones Industrial Average

6. A link to the P/E , earnings and dividend information on the the Dow Jones web site

7. Calculations of the fair value of the Dow Jones Industrial Average based on several scenarios

The overall conclusion of the analysis below is that an estimated  fair level for the Dow would be 14,853 (as a point estimate) and that at its current level (as of May 18, 2013) of 15,354 the Dow Jones Industrial Average is about fairly valued.

Mathematically, the Fair Value of the Dow Jones Industrial Average depends (only) on four things: i) the return that investors require, ii) the current earnings and dividend level, iii) the expected growth rate in earnings and dividends, and iv) the  expected 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 18, 2013. 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  16.7. This is neutral to moderately over-valued in attractiveness compared to the historical average of 15.5. Therefore the quick indication is that the DJIA index is fairly valued to moderately over-valued as at May 18, 2013 at 15,354. 

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 average annual 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, making a reasonable forecast of the 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 18, 2013 with the index at 15,354)

Data from the Dow Jones company are as follows:

Note: the data in the following table, including the historical earnings and P/E ratios, is reasonably accurate but should not be taken as exact since I was unable to find a good data source. This data was derived from data on the Dow Jones web site at various historical points in time, but that data was subject to later updates. 

DJIA Earnings Type	Annual Earnings on Dow Industrials	P/E Ratio at 15,354 DOW	Earnings Yield (1/P/E)
Actual latest year (trailing four quarters) GAAP earnings	$922	16.7	6.0%
Latest year operating  earnings (removes negative earnings) or otherwise "normalized"	$983	15.6	6.4%
Forecast forward GAAP earnings for the next year (next four quarters)	$1107	13.9	7.20%
Forecast forward operating earnings for the next year (removes negative earnings)	$1107	13.9	7.20%
For Comparison here are the DJIA earnings in prior years:		Historical GAAP P/E	Historical Earnings Yield
2012 GAAP Earnings at 13,104	$925	14.2	7.1%
2011 GAAP Earnings at 12,218	$724	17.9	5.6%
2010 GAAP Earnings at 11,578	$831	13.9	7.2%
2009 GAAP Earnings at 10,428	$624	16.7	6.0%
2008 GAAP Earnings at  8,776	$661	13.3	7.5%
2007 GAAP Earnings at 13,265	$831	16.0	6.3%
2006 GAAP Earnings at 12,463	$720	17.3	5.8%
2005 GAAP Earnings at10,718	$476	22.5	4.4%
2004 GAAP Earnings at 10,783	$592	18.2	5.6%

Note that our historical DOW earnings data were derived from Dow data sheets from December each year or early in each new year and were subject to updating and so should not be taken to be precise.

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 reasonably "representative" of "normal" expected economic conditions and has not been materially affected upwards or downwards by usual items.

The trailing year actual GAAP earnings on the DOW of $922 does not appear to have been unduly affected by unusual items and appears to be a reasonable estimate of the normalized earnings.

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. Note also, that the right and left hand scales are consistent, both rise 10,000 fold.

The above chart shows that the annual earnings on the DOW have trended 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 Dow earnings, on a GAAP basis, (the red line) had dipped noticeably after reaching a peak in 2007 but made almost a full recovery in 2010 but then dipped in 2011 but then surpassed the 2007 peak in 2012. The GDP figure shows a dip in 2009 which was more than fully recovered in 2010. Note that the GDP figures here are in nominal dollars, to be consistent with the earnings on the Dow, whereas most reports of  GDP growth refer to real, inflation adjusted dollars. In nominal dollars the U.S. GDP is significantly larger than it was prior to the financial crisis.

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 and then almost fully recovering by 2010 before faltering in 2011 and then fully recovering in 2012 (this is all on a GAAP basis, not normalized for unusual losses). 

The high DOW earnings in 2007 were somewhat above the trend line.

The Dow Jones Industrial Average represents a portfolio of 30 stocks. For each $15,354 (the current index value)   purchased, the underlying companies in the portfolio therefore earned  $922 in the past reported four quarters and currently pays a dividend of $15,354 * 0.0241 = $370 per year. 

When we buy the Dow Jones Industrial Average index, we can therefore think of it as being an investment or "stock" or (better yet) "business", that (as of May 18, 2013) costs $15,354 and currently earns $922 per year and pays a dividend of $370 per year. It is worth thinking about whether or not this "stock" is a good investment at or around its recent level of $15,354.

We know that the Dow Jones Industrial Average index was at 15,354 on May 18, 2013. We can estimate what the DJIA "should" have been trading at (or is worth) 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 (not adjusted down to remove 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, which lowers our historical P/E estimate). 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, assuming that investors will be satisfied with a projected return of 7% or 8% respectively due to 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. Quite possibly proprietary technology, scale advantages and brand loyalty may allow corporations to earn, even on new investments, 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 or justifiable 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 has been below 12.5 at times in the recent past, my earlier calculation of the sustainable or justifiable 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 6% to 8%, given today's abnormally low interest rates. 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 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	Required Return	DJIA Fair Value Today	Implied Fair P/E today	Return per Year Buying at 15,354
922	370	4%	13	17,742	6%	13,244	14.4	4.2%
922	370	4%	15	20,472	6%	14,768	16.0	5.5%
922	370	4%	17	23,201	6%	16,292	17.7	6.7%
922	370	4%	13	17,742	8%	11,242	12.2	4.2%
922	370	4%	15	20,472	8%	12,507	13.6	5.5%
922	370	4%	17	23,201	8%	13,771	14.9	6.7%
922	370	5%	13	19,524	6%	14,415	15.6	5.3%
922	370	5%	15	22,528	6%	16,093	17.5	6.6%
922	370	5%	17	25,531	6%	17,770	19.3	7.7%
922	370	5%	13	19,524	8%	12,223	13.3	5.3%
922	370	5%	15	22,528	8%	13,614	14.8	6.6%
922	370	5%	17	25,531	8%	15,005	16.3	7.7%
922	370	6%	13	21,465	6%	15,686	17.0	6.3%
922	370	6%	15	24,767	6%	17,530	19.0	7.6%
922	370	6%	17	28,070	6%	19,374	21.0	8.8%
922	370	6%	13	21,465	8%	13,286	14.4	6.3%
922	370	6%	15	24,767	8%	14,815	16.1	7.6%
922	370	6%	17	28,070	8%	16,345	17.7	8.8%

 

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  11,242  (we would earn an average 4.2% per year, buying today at 15,354 under these assumptions) to 19,374 (we would expect to earn an average 8.8% per year, buying today at 15,354 under those assumptions). A reasonable scenario may be average of the two highlighted rows with 5% earnings growth per year, a 7% (average of 6% and 8% in the two rows) required rate of return and a final P/E ratio of 15 in ten years and a fair DOW level of 14,853 and an expected return of 6.3% per year on average. However, other scenarios are certainly plausible as well.

Note however that all estimates assume the $922 actual trailing GAAP earnings is the current representative normalized earnings on the DOW. 

Since the Dow Jones Industrial Average is currently  at 15,354, I conclude that it is likely about fairly valued. The point estimate based on this analysis is that it is about 3% over-valued.

The table illustrates quite a wide range for a reasonable fair value of the Dow Jones Industrial Average. 

Some investors might not admit to being happy with a 7% expected long-term return from stocks, but 7% seems highly attractive compared to a current 10 year U.S. government bond yield of just 1.9%.  

Note also that the Price to book ratio of the Dow Jones Industrial Average is 2.99. The DJIA companies have therefore achieved a return on ending equity of about 17.9% in the past year based on ROE = P/B divided by P/E.

Another way to calculate the expected return on the Dow Jones Industrial Average index is by using the dividend growth model. This assumes that the dividend will grow at the rate of the ROE on retained earnings times the proportion of earnings that are retained.  The dividend payout ratio calculated from the dividend and earnings in the table above is $370/$922 = 40%. That means the earnings retention ratio is 60%. If the DJIA companies could continue to make the same ROE of 17.9% on their existing equity plus on retained earnings then the dividend would grow at 60% of that or 10.7%. Adding the current dividend yield of 2.4% would then suggest an expected return of about 12.9%, assuming the P/E was unchanged. However, a 17.9% ROE on future as well as past retained earnings seems quite optimistic. If we use a 10% ROE on new investments (of future retained earnings) the expected return on this basis is about 8.4% (6.0% plus 2.4%). And this assumes that the P/E remains constant at 16.7. 

The overall conclusion is that a fair level for the Dow would be 14,853 (as a point estimate) and that at its current level (as of May 18, 2013) of 15,354 the Dow Jones Industrial Average is about fairly 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 investors' 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.

One more thing. Notice that the table above predicts that the DOW will be at 22,528 in ten years ( the year 2023). This is based on the current earnings of $922 growing at an average of 5% per year and a P/E of 15 being applicable in 2022. That does not seem like an overly aggressive couple of assumptions. This illustrates why Warren Buffett is so confident that his equity index puts will end up costing him nothing. In all probability he will never pay anything out on those puts. And meanwhile Berkshire will have received a large premium up front when it sold those index puts to investors and will have kept that money and the earnings made by investing that money for about fifteen years. At that point all the recent worry about mark to market losses on those index puts in recent years will have been proven to be nothing more than accounting nonsense. Recall the puts sold a few years ago essentially consisted of Berkshire being paid a large up-front premium and it would only have to pay out if the Dow or three other stock market indexes failed to rise over a period of time that was approximately 15 years.

You can easily invest in the Dow Jones Industrial Average Index index by buying the SPDR Dow Jones Industrial Average

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 18, 2013 

This is an update of an analysis I first did of the DJIA dated February 8, 2002 Click to check out what the anaylsis was indicating way back then.

The table below shows how this analysis has performed in the past. This assumes that today's level of the DOW at 15,354 is a fair value of the DOW rather than the 14,853 that our calculation indicates we "should" be at. The results are mixed. Our fair value of the DOW estimates in the earlier years were too optimistic. In recent years it appears to be working better perhaps due to enhancements and to better consideration of whether the beginning earnings needed to be normalized or not and due to a correction to the long-run average P/E ratio.

 

Date of prior calculations	DJIA Level	Fair Value we Calculated	We Indicated Market appears:	Average Capital Gain Per Year (Annualized)	Apparent Performance as of May 18, 2013 with Index at 15,354
January 12, 2013	13,488	14,165	about fair-valued	45.6%	It appears we were too cautious
March 4, 2012	12,978	15,072	under-valued	15.0%	It appears we were correct
March 6, 2011	12,170	11,997	about fair-valued	11.1%	It appears we were too cautious
September 11, 2010	10,463	11,779	under-valued	15.4%	It appears we were correct
May 29, 2010	10,137	10,975	under-valued	15.0%	It appears we were correct
October 11, 2009	9,865	11,026	under-valued	13.1%	It appears we were correct
April 4, 2009	8,018	9,146	under-valued	17.1%	It appears we were correct
December 6, 2008	8,635	10,317	under-valued	13.8%	It appears we were correct
November 6, 2008	8,696	10,506	under-valued	13.4%	It appears we were correct
June 8, 2008	12,182	12,931	under-valued	4.8%	We now appear too optimistic as the $803 earnings from June 2008 declined before finally recovering. 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.
September 8, 2007	13,113	13,214	about fair-valued	2.8%	We were too optimistic as we did not project a sharp earnings decline.
September 15, 2006	12,446	12,009	about fair-valued	3.2%	We were too optimistic,  the earnings, then at $720 did not grow as expected.
May 31, 2005	10,467	10,912	about fair-valued	4.9%	We were too optimistic,  the earnings, then at $661 did not grow as expected.
November 30, 2004	10,428	10,716	about fair-valued	4.7%	We were too optimistic,  the earnings did not grow as expected.
February 8, 2002	9,744	9,820	about fair-valued	4.1%	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 way 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. We said: 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.