Dow 18,500? The case for believing

Take the Dow's top holding, IBM Corp. (IBM, news, msgs), for example. We have a $120-a-share fair-value estimate on that stock. Provided that the company 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.

Changes in the Dow's portfolio

This move invites a few questions:

First, how will this affect our take on the Dow? The short answer 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.

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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.

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Here, too, we're not very 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, or 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.

This article was written and reported by Jeffrey Ptak for Morningstar.

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