Why the Dow Looks Expensive

One of the many fun things about working at Morningstar is that we cover so many companies. With such a broad coverage universe, we can use the fair value estimates that our analysts calculate to make some interesting generalizations about the level of the market. For example, by aggregating the fair value estimates for the stocks in a particular index, such as the Dow Jones Industrial Average, I can get some sense of where the broad market is trading relative to the total present value of all those companies' future free cash flows. (At least, relative to our estimates of those future free cash flows.)

I went through this exercise in early December of last year, using the Dow as a market proxy. I used the Dow largely because it's a straightforward calculation: Sum up our fair value estimates, divide by the Dow's current divisor, and there you are. At the time, our estimated fair value for the Dow was about 9,200, and the index was trading at about 8,750. That meant that we thought the Dow was mildly undervalued, to the tune of about 5%.

With the market value of the Dow now at about 9,850--more than 1,000 points higher than last December--I thought it would be worth revisiting the question to see what our fair value estimates are saying about the Dow right now. Surprisingly, our fair value estimate is almost exactly the same. (Technically, it's risen 0.5% to 9,230 from the previous 9,180 estimate, but such a small difference is just noise.) So by our estimate, the Dow is now 6% overvalued.
 
Back in December, we thought that nine of the Dow stocks were overvalued, 11 were undervalued, and 10 were about fairly valued. Those distributions have changed somewhat, but not all that much. We still think 10 of the Dow's stocks trade right about where they should, while eight look undervalued and 12 look overvalued. (You can click here for current quotes on all of the Dow stocks, and Premium Members can click through to see our most recent Analyst Reports and fair value estimates.)

So, what’s our track record been like on Dow stocks over the past 11 months? We've lowered our fair value estimates for seven of them, raised our fair values on nine, and we've left the remaining 14 pretty much unchanged. Last time I looked at the Dow, we thought  McDonald's (MCD) and  Home Depot (HD) looked like two of the most compelling values in the index, and they've done quite nicely since. Mickey D's is up about 34% since then, and Home Depot has soared almost 40%. At the time, we also thought  J.P. Morgan Chase (JPM) looked pretty cheap at $25, since our fair value estimate was $36. Our fair value hasn't changed since then, but the stock sure has, shooting up 40% in the past 11 months. Finally, we nailed  IBM (IBM) and  Merck (MRK). Both looked like they were mildly overvalued last December, and IBM has essentially treaded water for the past year, while Merck has fallen about 25%.

On the flip side, we missed a few--though our errors were more of omission than commission. Last December, we had  General Motors' (GM) fair value pegged at a level much higher than the stock's price, but by taking a more negative view of the firm's competitive position and future auto demand (which has been pulled into the present by generous incentives), we slashed our fair value by more than half. The stock is essentially unchanged since then, so it looks like this was the right call, but we clearly erred by having such a high fair value estimate in the first place.

We also missed two of the Dow's biggest gainers over the past year,  Caterpillar (CAT) and  Intel (INTC). Although we'd liked Cat at $38 in September 2002, we thought $49--the stock's price last December--was too high a price to pay. The market has clearly disagreed with us, however, sending the shares up almost 50% since then to about $75. We're sticking to our story, however, and we think the shares are quite overvalued at the moment. 

We also underestimated the strength of the recent rebound in demand for chips, which has sent Intel's shares up almost 60% over the past year. Although we’ve boosted our fair value from $15 a year ago to $21 now to reflect this, we still think investors are currently overpaying for the stock. (To justify a $34 price, Intel would need to increase sales at 15% per year and achieve operating margins of 35% for the next five years. Since the firm only generated results of this caliber during the boom years of the late 1990s, we think it's an unlikely scenario.)

At the moment, Intel, Cat, GM,  Alcoa , and  Eastman Kodak  are the most overvalued Dow stocks, by our estimates, while McDonald's and  Microsoft (MSFT) are the only Dow components that are within shouting distance of being interesting. (McDonald's would need to fall about 10% to be worthy of a 5-star rating, while Microsoft would need to slip by just a buck and a half to hit 5 stars.)

So, on balance, we're not seeing a lot of value in the large-cap stocks that make up the Dow right now. Our fair value estimates were right, in aggregate, 11 months ago when they had the Dow pegged as being mildly undervalued. Let's see whether we can go 2-for-2.