Issue: 100
Sent: 04-03-2008 10:49:01
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Going Up?
Given the current uncertainty in the markets, a suggestion that the Dow Jones Index is likely to rise by 6000 points over the next three years is unexpected. Lets be clear, this is a forecast that the Dow Jones Industrial Average will reach 18500 by the year 2011. Sounds more than a little crazy yet I found this starling piece of news on a highly respected website, namely the Morningstar site in America.
The prediction is made by Jeffery Plak, Morningstar's director of exchange traded securities analysis and editor of Morningstar annual guide on Exchange Traded Funds, (he is also a CFA and a CPA by the way). He argues that as at February 7 2008, fair value on the Dow was in fact around 14,000, yet it was trading at a 17% discount to this figure. He indicated that the last time it looked this 'cheap' was in September 2002 when it stood at around 7500. Three years later it had risen approximately 3000 points to over 10500.
They came to the 18,500 figure by considering the fair value estimates their equity analysts have placed upon each of the Dow's constituent stocks. They took these fair value estimates, the Dow's market price and added in its 9.7% weighted average cost of equity and came up with an annualised expected return of 17%. This they claim represents the return an investor would receive if the prices of the 30 stocks that comprise the Dow converged to the fair values estimates placed upon them, over a three-year period.
They then deducted the Dow's 2.2% dividend yield from the annualised return and compounded the indexes closing value on February 7 by this 14.8% annualised price return and hey presto, out comes 18510 in three years time. Sounds unrealistic, but I remember hearing about predictions of the Dow reaching 10,000 back in the mid 90's when the index was below 4000 and thinking that the forecast was far fetched, yet it happened.
As Plak points out, they have not undertaken a top down macroeconomic view of things, they have not considered where interest rates are going let alone the US dollar. Instead they have built up their forecast by looking at each company that is part of the Dow, considering their intrinsic value. He argues that whilst they are mindful of how the economy could impact a firm's results, it has not governed their outlook. In this regard they believe that a business' value is a function of the cash it is likely to generate over a period of years, not just the next few quarters. Sounds a reasonable argument, i.e. it is not something that is derived from gazing at tea leaves.
They do point out that there is less than 2000 points difference between where the Dow is currently trading and their fair value estimate, producing the question of where the other 4000 or so points come from. This they argue is a consequence of the Dow's weighted cost of equity.
They state that their fair value estimates are not static, i.e. based on one point in time, but instead are compounded over time at a certain rate, the COE. That compounding is designed to reflect the ongoing receipt of cash flows that will naturally increase a company's intrinsic worth. Consequently, (so the argument goes), if a company's actual results roughly approximate to the forecast, then the company's intrinsic value should increase at the cost of equity.
In fairness to Plak, he adds the caveat that of the fair value estimates produced by his analysts don't compound at the cost of equity, then the forecast is null and void
Who knows, perhaps Plak and his team of analysts at Morningstar have something, only time will tell. If nothing else it is good to encounter some optimism at least.
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