Dow Jones Fair Valuation Model - 13,500 - gregdonaldson

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Dow Jones Fair Valuation Model - 13,500
Sep 03, 2008 09:26 PM UTC

gregdonaldson

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Via Donaldson Capital: Rising Dividend Investing:

How cheap are stocks? You don't hear that question often these days, but we believe that is the appropriate question to ask as we pass through the one year anniversary of the subprime crisis.

Bank write offs have been staggering and many analysts believe some of the write offs will later be recaptured as the markets unfreeze and normal business activity returns to banking and real estate. Even if earnings are not recaptured, losses at some point will cease and the banks will again begin reporting earnings, thus the earning we are seeing today for the major indices are understated significantly from what they are likely to be two to three years down the road.

Having said this, we believe the Dow is undervalued even using 2008 projections for dividends and earnings. We have computed the "fair value" of the Dow Jones Industrials using current data from S&P on 2008 projected dividends, earnings, and AAA corporate bonds yields.

Using these assumptions, we then ran the the data through our Valuation Model(click to expand), and we arrived at a fair value of 13,500, as shown on the chart above.

The chart shows that the valuation bars, in blue, have followed closely the actual price (except during the mania of the late 90s) of the indices shown in red. With price now buried deep in the value bar for 2008, our model is signaling that stocks are undervalued.

The standard error for the formula is about 900 points. That would mean that current "fair value" range for the index should be somewhere between 12,600 and 14,400 -- even the bottom range of the model is appreciably above the Dow's current level of 11,500.

We believe the Dow is currently discounting a much slower overall earnings and dividend growth landscape than we are likely to experience, thus we continue to believe that stocks, even in these uncertain times, are undervalued.

As we always say, our model is based on historical relationships and thus is not a guarantee of future results. It is, however, based on long-term relationships between growth, interest rates, and price.

An important truth that most people miss is that the 30 companies in the Dow will likely raised dividends nearly an average of 10% for 2008, including Citigroup which cut its dividend 40%. That is a clear signal that these major multinational companies do not believe that the economy is going to fall off a cliff.

We'll have a new reading of the valuation model on a regular basis.

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