We Think the Dow Is Trading at a 30% Discount
Our Morningstar fair value estimates imply a Dow value of at least 12,500.
Stock Strategist
Make no mistake about it, Mr. Market is very depressed. Newspapers are flush with headlines of impending doom and economic peril. The Dow is trading at levels not seen since 2003, with some of the components' stock prices trading at multidecade lows, and any investor checking his or her investment portfolio is certain to be singing the blues.
However, as the father of value investing, Ben Graham, guides us, the mercurial Mr. Market can be our friend, as his overreaction often presents us with great buying opportunities. Here at Morningstar, we believe the market is providing several great long-term buying opportunities, with our coverage universe trading at the steepest discounts we've seen since we started valuing equities. In our opinion, we think a more selective group of companies, the Dow Jones Industrial Average, is undervalued by at least 30%.
Changes in the Dow in 2008
In February 2008, we wrote an article stating that our estimate of the Dow's fair value was around 14,000 and trading at a 17% discount. Since then, many changes have unfolded, including the collapse of both Bear Stearns and Lehman Brothers and what was essentially a government takeover of Fannie Mae (FNM) and Freddie Mac (FRE). Oil prices have fallen nearly 70% from their highs, bankruptcies have spiked, and the economy has sputtered. AIG (AIG) was kicked out of the Dow and replaced by Kraft (KFT) after the government rescued the insurance giant in September.
The Dow has fallen about 30% since the February 2008 article, and many of our fair values for the components have changed as well. Our new fair value estimates imply a Dow value about 11% lower than our previous estimate in February. Over the past 10 months, we've raised our fair value estimates for four of the components ( Chevron (CVX), McDonald's (MCD), IBM (IBM), and Hewlett-Packard (HPQ)) and held our fair value estimates in place for nine of the components, including Johnson & Johnson (JNJ) and Procter & Gamble (PG).
However, as dilutive capital raises and lower earnings expectations funneled in over the months, our analysts cut fair values for the remaining 17 components. Not surprisingly, the most dramatic cuts have been for financial firms such as Citigroup (C) (fair value down 71% since February) and Bank of America (BAC) (fair value down 37% since February) and commodity plays like Alcoa (fair value down 79% since February). Overall, we have cut fair values of the Dow components by an average of 16%.
We Believe the Dow Is Undervalued
Despite our overall lower valuation of the Dow, we still believe it is undervalued. Our Morningstar fair value estimates imply a Dow value of at least 12,500, implying roughly a 30% discount from the closing price on Dec. 12. This discount is much wider than the 17% discount we estimated in February, as we think Mr. Market has overreacted to the deluge of negative news in recent months. Of the 30 Dow components, 17 are rated 5 stars, eight are rated 4 stars, four are rated 3 stars, and one is 1 star as of Dec. 12. Also, despite our higher overall uncertainty about the economy, 23 of the 30 components carry low or medium uncertainty ratings.
| Dow Components | |||||
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| Uncertainty | Fair Value Estimate | Closing Price Dec. 12, 2008 | Price/ Fair Value Estimate ( % ) | Star Rating | |
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| Alcoa | High | $9.50 | $10.08 | 106.1% |
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| American Express (AXP) | Medium | $58.00 | $20.34 | 35.1% |  |
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| Boeing (BA) | Very High | $53.00 | $39.20 | 74.0% |  |
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| Bank of America (BAC) | Very High | $44.00 | $14.93 | 33.9% | |
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| Citigroup (C) | Very High | $14.00 | $7.70 | 55.0% |  |
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| Caterpillar (CAT) | Medium | $72.00 | $42.08 | 58.4% | |
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| Chevron (CVX) | Medium | $109.00 | $79.00 | 72.5% | |
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| Du Pont | High | $39.00 | $26.61 | 68.2% | |
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| Disney (DIS) | Low | $34.00 | $22.61 | 66.5% | |
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| General Electric (GE) | Medium | $28.00 | $17.11 | 61.1% | |
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| General Motors (GM) | Very High | $0.50 | $3.94 | 788.0% |
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| Home Depot (HD) | Medium | $35.00 | $23.47 | 67.1% | |
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| Hewlett-Packard (HPQ) | Medium | $63.00 | $35.97 | 57.1% | |
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| IBM (IBM) | Low | $136.00 | $82.20 | 60.4% | |
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| Intel (INTC) | Medium | $23.00 | $14.75 | 64.1% | |
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| Johnson & Johnson (JNJ) | Low | $80.00 | $57.25 | 71.6% | |
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| J.P. Morgan (JPM) | Very High | $49.00 | $30.94 | 63.1% | |
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| Kraft (KFT) | Medium | $40.00 | $26.96 | 67.4% | |
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| Coca-Cola (KO) | Low | $59.00 | $44.57 | 75.5% | |
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| McDonald's (MCD) | Low | $59.00 | $60.59 | 102.7% | |
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| 3M (MMM) | Low | $85.00 | $56.04 | 65.9% |
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| Merck (MRK) | Medium | $50.00 | $27.04 | 54.1% | |
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| Microsoft (MSFT) | Low | $35.00 | $19.36 | 55.3% | |
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| Pfizer (PFE) | Medium | $31.00 | $16.92 | 54.6% | |
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| Procter & Gamble (PG) | Low | $77.00 | $58.94 | 76.5% | |
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| AT&T (T) | Medium | $35.00 | $28.18 | 80.5% | |
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| United Technologies (UTX) | Medium | $64.00 | $48.82 | 76.3% | |
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| Verizon (VZ) | Medium | $39.00 | $32.80 | 84.1% | |
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| Wal-Mart (WMT) | Low | $60.00 | $54.63 | 91.1% | |
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| ExxonMobil (XOM) | Low | $91.00 | $80.45 | 88.4% | |
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Some of the components are in businesses that have proved to be quite recession-resistant over the past months, and as such, the stocks are performing well and trading close to our fair value estimates. Stock prices for McDonald's and Wal-Mart (WMT), for example, both reached all-time highs in the third quarter this year. (See our recent Strategist article about McDonald's stock performance, "Why Buy McDonald's?") Most other components have traded down on general market fears, pushing the stock prices well below our estimate of the firms' long-term value. For example, since February our fair value estimates have remained in place for Pfizer (PFE), Microsoft (MSFT), Kraft, and many others, as our analysts believe the long-term values of these stocks are intact. However, the stocks have sold off and now trade at attractive 5-star prices.
One standout in the Dow is the only component that we believe is overvalued: General Motors (GM). Our analyst David Whiston sees little value in the firm's common stock and believes that investors should steer clear, as bankruptcy or government intervention seem to be the most likely outcomes. Our fair value estimate for GM is $0.50 per share, with a very high margin of safety around our fair value estimate.
Why the Dow Matters
With so many more stocks in our coverage universe trading at hefty discounts to our estimates of their intrinsic values, many beyond the 30% discount we derive for the Dow, why should our valuation of the index matter? To us, the Dow contains a broadly diversified collection of the type of companies we love best: high-quality firms that generate copious cash flows that are protected by economic moats. Many are the strongest and most profitable in their industries, and nearly all have businesses that span the globe.
Even with the assumption that GM is virtually worthless, and given the many fair value cuts in the Dow components we've made in the past months, we believe the long-term intrinsic values of these diversified large-cap stocks taken as a whole are well above the market prices. Why the difference? Our analysts value companies as businesses that generate cash flows over very long periods of time. We're mindful of the weak economy and how that impacts near-term cash flows, but we have a much more tempered valuation methodology than Mr. Market, who is governed by short-term whims. But don't let Mr. Market's gloom and despair fear you. As Warren Buffett advises and as our fair value estimates imply, you might do well to turn that fear into greed.