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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.

Caveat
In summary, our research suggests that the Dow will rise more than 6,000 points in the next three years. However, there were only about 1,750 points separating the Dow's recent 12,247 index value from our 14,000 fair value estimate. So, where do the other 4,250 or so points come from? In a nutshell, they come from the Dow's weighted average cost of equity.

Let us explain. Our fair value estimates aren't static. They compound over time at a certain rate--the COE. That compounding is meant to reflect the ongoing receipt of cash flows, which gradually increase a company's intrinsic worth. Therefore, if a firm's actual results (i.e., cash flows) roughly approximate what we've forecast, then that business' intrinsic worth should increase at the cost of equity.

Take the Dow's top holding, IBM IBM, for example. We have a $120 fair value estimate on that stock. Provided that the firm hauls in cash at the pace we've forecast, we'd expect IBM's fair value to approach $131 in one year ($120 fair value compounded at stock's 9.5% cost of equity over 12 months), $144 in two years, and $158 in three years. Those increases are attributable to the incremental receipts of cash flow that take place.

Logic notwithstanding, the caveat is that if our fair value estimates don't compound at the cost of equity, then the Dow won't be worth the 18,510 we're projecting in three years.

Postscript: As this article went to print, the Dow Jones Index Selection Committee announced that it was replacing two Dow components, Honeywell HON and Altria MO, with banking colossus Bank of America BAC and oil producer Chevron CVX. The change is set to take effect on Feb. 19, 2008.

This move invites a few questions. First and foremost, how will this impact our take on the Dow? The short answer to that question is--it won't hurt. Honeywell and Altria were trading at 11% and 2% discounts to their fair value estimates, respectively, as of Feb. 7. Bank of America and Chevron, by contrast, were trading at 38% and 20% discounts, respectively, as of that date. In other words, the committee has replaced Honeywell and Altria with a pair of stocks that look even more undervalued. In addition, we don't think these changes fundamentally alter the portfolio's risk profile. The upshot is that the changes are likely to make the portfolio more, not less, attractive from a valuation standpoint.

The second question is whether the Dow committee will end up making a host of other changes to the Dow's portfolio. After all, in making our forecast of an 18,500 index value, we assumed that the Dow's current portfolio would remain more or less intact for the next three years. Here too we're not too concerned. Although the index has hardly been static, it has not been a revolving door either. For instance, the committee has replaced 20 companies in the past two decades (including the impending changes), which works out to roughly one replacement per year. In short, index turnover hasn't been a major issue in recent years (these latest changes are the first since 2004). Given that, we're not especially worried that the portfolio we used to value the Dow will end up looking like the relic of a distant past in a few years.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Jeffrey Ptak, CPA, CFA, is Morningstar's director of exchange-traded securities analysis.

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