by Tim Melvin | July 10, 2014 2:44 pm
Is the Dow Jones Industrial Average too high? That’s one of those questions that pundits and gurus are always asking, and the answer is a bit tricky.
Too high compared to what?
Do we measure it compared to earnings, assets, dividends or future predicted earnings? Do we consider the index in aggregate or consider the individual companies? Once we answer the question itself we need to decipher what (if anything) the answer tells about potential future market behavior.
According to this week’s Barron’s, the DJIA trades at 15.54 times earnings and 3.38 times book value. That’s not awful, but things change up a bit when we look at the companies themselves rather than the aggregate index. The average company in the index is trading at 18.2 times earnings; the average price-to-book is 4.29 right now, which strikes me as a very high multiple of assets for the type of large companies that are in the index.
The picture becomes a little clearer if we look at earnings results and potential. In the past five years the average company in the index has grown earnings by about 8.5%, and analysts are looking for similar performance over the next five years. That gives us a PEG ratio of more than 2 based on average growth rates … which also strikes me as far from cheap for slow-growth companies such as those in the index.
Also? No stocks in the Dow are trading below book value right now. Only four stocks are trading for less than 2 times book value. Only one stock, Travelers (TRV), sells for less than 10 times earnings. Eleven companies trade for more than 20 times earnings.
Bottom line — I don’t see any bargain Dow stocks, nor much of a margin of safety right now.
Next I stepped back and did a calculation of the DJIA using the Graham formula for fair value. This simple formula developed by Ben Graham takes earnings and assets into account to get a fair value for a company — when I apply it to the index, I get a very unhappy result. This conservative valuation measure comes up with a fair value for the index of just 11,136 right now. If I use some of the most aggressive estimates for earnings and book value growth for the next year, I can get that number up to 12,100 … but no higher.
I think we have answer the question of whether the Dow is cheap — but what can we do with this information to make money in the market? The most obvious takeaway: Don’t buy the index or ETFs that track it right now. I wouldn’t buy any of the components this level, either.
Does this overvaluation of the index and its components mean we should rush to sell our stocks? No, it does not. We have seen by now that overvalued companies can always become more so — especially in a zero-interest-rate world. We should add this to our growing collection of warning lights — including signals like market cap to GDP, and the Value Line Median Appreciation Index — and become a lot more careful and cautious about managing our portfolios. Limit your buying to only true bargain issues, and consider selling some of the more overpriced issues in your portfolio.
At the time of publication, Melvin had no positions in the stocks mentioned.
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