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The Surprising Reason the Dow Jones Industrials Could Keep Soaring

The Dow Jones Industrials (DJINDICES: ^DJI  ) stand at a new all-time record, the eighth record close so far in 2014 and the 60th time the Dow has set a record since the financial crisis. With the Dow having now climbed well over 150% since early 2009, many investors believe that the stock market is overvalued. But at least by one metric, the Dow could easily have a lot more room to run higher -- although a lot of the Dow's success will ride on IBM (NYSE: IBM  ) , Goldman Sachs (NYSE: GS  ) , and Chevron (NYSE: CVX  ) .

Multiply this
You'd think that after such huge gains in just five years, the Dow Jones Industrials would almost have to be expensive. But even using the most basic of valuation techniques gives some reassurances that the Dow hasn't gotten ridiculously out of line with historical levels.

According to data from Thomson Reuters, the Dow currently trades at about 15 times current projections for full-year 2014 operating earnings for its 30 component stocks. Even accounting for the fact that operating earnings are higher than the net income figure on which earnings per share are typically based, a P/E of 15 is reasonably in line with historical levels for the Dow.

Moreover, projections further into the future predict even stronger earnings for the Dow next year. A jump of almost 7% in operating earnings might not seem like much, but it's enough to knock a full point of the earnings multiple for the Dow on a forward basis.

The keys to Dow earnings
Yet as with other things about the Dow Jones Industrials, it's important to understand the vagaries of the unusual way in which the Dow is calculated in order to assess the impact of earnings growth of individual companies on the average's overall P/E. Just as the stocks with the highest share prices have the biggest impact on the Dow's calculated value, so too do the stocks with the greatest earnings per share have the biggest influence on the aggregate Dow earnings figure.

Source: IBM.

Currently, IBM has the greatest per-share earnings, with operating earnings approaching $18 per share this year and $20 per share for 2015. Even though the tech giant has had difficulty with falling revenue, its emphasis on higher-margin business lines has helped it keep its per-share profit rising, in conjunction with extensive share repurchases. Eventually, though, IBM needs to start making a better showing against its competitors if it wants to sustain its earnings growth, and the stock's weak performance expresses investor skepticism about IBM's prospects of doing so.

Goldman Sachs and Chevron are in somewhat similar situations. Goldman Sachs has had to deal with a more intense regulatory environment, while Chevron struggles with the ongoing need to find new sources of production to replace played-out oilfield assets. Shareholders have assigned relatively cheap earnings multiples on the two stocks because of doubts about their ability to keep growing, and for now, those fears appear justified. Chevron will have to prove that it can find economically viable new resources in order to keep its pace of growth high, while Goldman Sachs will have to keep maneuvering the ever more complex web of regulation in the financial industry in order to stay on the growth side of the curve.

What's surprising is that given these fears, investors still expect the earnings of these three stocks to rise. If they do, moreover, they could easily justify richer multiples for the Dow overall -- sending the average much higher in the months and years to come.

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Dan Caplinger

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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8/28/2015 4:55 PM
^DJI $16643.01 Down -11.76 -0.07%
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Goldman Sachs CAPS Rating: ***
IBM $147.98 Down -0.56 -0.38%
International Busi… CAPS Rating: ****