Dow 18,500? The case for believing

By Morningstar

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

As of Feb. 7, the Dow was trading at a very hefty 17% discount to our estimate of its fair value, which stood around 14,000. We based that 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 with 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 compounded the Dow's closing value Feb. 7 by this 14.8% annualized price return, we arrived at an 18,510 index value.

No shortcuts in our estimate

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 or the size of the trade deficit. 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.

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 affect a company's results in the near term, it doesn't govern our outlook. In short, we think that a business's 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. What's more, we've canvassed our analysts to get their perspectives 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.

A caveat

In summary, our research suggests 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 cost of equity. That compounding is meant to reflect continuing cash flows, which gradually increase a company's intrinsic worth. Therefore, if a company's actual results (i.e., cash flows) roughly approximate what we've forecast, then that business's intrinsic worth should increase at the cost of equity.

Continued: Move raises questions

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