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Dow 18,500? Believe It

Why we think the Dow will rise more than 6,000 points in the next three years.

Jeffrey Ptak, 02/19/2008

We think the Dow Jones Industrial Average will rise more than 6,000 points to roughly 18,500 over the next three years.

How We Arrived at That Estimate
The Dow was trading at a very hefty 17% discount to our estimate of its fair value, which stood at around 14,000 as of Feb. 7, 2008. We base that fair value estimate on the fair value estimates that our equity analysts have placed on the Dow's 30 component stocks. The Dow hasn't looked this cheap to us since September 2002 when the index stood at 7,592 (three years later it had risen to 10,569).

When we take the Dow's market price and fair value estimate together with its 9.7% weighted average cost of equity (our analysts assign a percentage cost of equity to every stock they cover, including all of the Dow's components), it translates to a 17% annualized expected return. In other words, this is the return an investor would reap if the prices of the Dow's components converged to our fair value estimates over a three-year holding period (not ad infinitum).

To isolate the Dow's expected price return--which is what directly influences the index's value--we deducted the benchmark's 2.2% dividend yield from the 17% annualized return we derived. When we compound the Dow's closing value on Feb. 7 by this 14.8% annualized price return, we arrive at an 18,510 index value.

No Top-Down, No Short Cuts
Notice what's absent from the approach we've taken: a top-down macroeconomic overlay of any kind. For instance, we're not guesstimating the short-term direction and level of interest rates, the trajectory of the dollar, the size of the trade deficit, and so forth. Nor are we shortcutting our way to a forecast by, say, ginning up an aggregate earnings growth projection or trying to handicap where earnings multiples and yields are likely to settle in three years. Methods like these are notoriously imprecise. So, we don't use them.

Instead, we've built our forecast one company at a time by rolling up the fair value estimates that our analysts have placed on the Dow's components. When our analysts estimate a firm's intrinsic worth, they're forecasting cash flows over a very long time horizon. Therefore, while we're mindful of how the economy could impact a firm's results in the near term, it doesn't govern our outlook. In short, we think that a business' value is a function of the cash it's likely to generate over many years, not the next few quarters or so.

What the Market Is Missing
That distinction becomes very plain when we take a closer look at many of the Dow's cheapest names. To that end, we've published a companion piece--"Anatomy of a Bargain: Diamonds Trust"--in which we more closely examine why many of the Dow's components look so darn cheap.

In that piece, you'll find a synopsis of the Dow's valuation from a high level and our take on whether it's a bargain or not. What's more, we've canvassed our analysts to get their perspective on what the market is missing, so to speak, in its valuation of some of the Dow's cheapest names. For each of those stocks, we've provided a capsule summary of why our analysts think these firms are so inexpensive to begin with.

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