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Valuing the DJIA

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By StarryNightShade
May 30, 2008

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The following was posted by me on a subscription board, but since it deals with valuation - and because I learned how to shamelessly pick up rec's from the best - I thought I'd put it on the new board.

The DOW Jones Industrial Average Companies:

First revenue for the past three years: [Note a purist would have calculated calendar years, but I was lazy and just used the most recent annual report, which means in some cases a year ending in mid 2007 and in other cases early 2008.]

2005 - $2.56 Trillion
2006 - $2.81 Trillion (Year-over-year (YoY) growth of 9.9%)
2007 - $3.04 Trillion (YoY growth of 8.1%)

In comparison, 5 years early revenues were:

2000 - $1.83 Trillion
2001 - $1.82 Trillion (YoY growth of -0.5%)
2002 - $1.84 Trillion (YoY growth of 1.2%)

The 5 year growth annual growth rate based on averages over each 3 year period was 8.9%

Doing the same for earnings:

2005 - $230 Billion [Profit margin 9.0%]
2006 -$288 Billion (YoY growth of 25%) [Profit margin 10.3%]
2007 - $265 Billion (YoY growth of -8%) [Profit margin 8.7%]

Compared to:

2000 - $170 Billion [Profit margin 9.3%]
2001 - $141 Billion (YoY growth of -18%) [Profit margin 7.7%]
2002 - $143 Billion (YoY growth of 1.5%) [Profit margin 7.7%]

The 5 year growth annual growth rate based on averages over each 3 year period was 11.6%

Clearly revenues are far more consistent from year to year than profits. Leverage works two ways. Profits can grow faster than revenues, but can also fall off faster than revenues. The 5 year growth rates do even out somewhat with the differences in the growth rates due to the average profit margin for the 2000-02 period being 8.3% compared to 9.3% in the more recent 2005-07 period, which is might be explainable by the overall state of the economy in each period than the ability of companies to improve profit margins. Note that margins in the most recent year, 2007, have fallen back to 2000 levels.

That ends the comparison with the 2000-02 period, back to the more recent period of 2005-07

Cash back to Shareholders

2005 - $123 Billion
2006 - $101 Billion
2007 - $115 Billion

Share Repurchases
2005 - $116 Billion
2006 - $175 Billion
2007 - $211 Billion

Of course, not all share repurchases lead to a reduction in shares outstanding since employees are granted stock or exercise stock options. I handled this in a simple cash-in-and-out method. When employees exercise options they pay the strike price and the company gets a tax benefit. I also add in the value of the stock options granted during the period for a total amount "paid in" by employees. I convert this to the number of shares the employees could have purchases at fair market prices and then subtract that from the number of stock options exercised. The remainder is the number of shares provided at "no cost" to employees. The fair market value of these "no cost" shares is subtracted from the share repurchases. That number over the entire 3 year period is $33 Billion or an average of $11 Billion per year or between 5% and 10% of share repurchases and between 3% and 5% of total payouts. I was surprised. I thought it would be higher. However, remember that the DOW companies are not a representative sample of all companies. They are the larger, more mature companies.

Also a surprise was that the DOW companies nearly returned the amount equal to earnings. A net total of $744 Billion of profits (subtracting out reductions in cash holdings such as with Microsoft) were returned through dividends and share repurchases compared to $750 Billion of total profits over the three years. There may be more than 30 reasons for that, but it would seem to indicate that company executives were not seeing many places to invest earnings.

A few last statistics before estimating the "fair market" value of the DOW or equivalently the market implied discount rate or return built into the current price (or at least when I downloaded the values a couple of weeks ago).

Total Market Value = $4.1 Trillion
Total Equity as of 2005 = $1.4 Trillion
ROE = 17.4%

Intrinsic Value through Discounted Cash Flow Calculations

Case 1: Stable Growth with current retention ratio of profits = 0.9% (not likely, but let's start here anyway.)
The implied growth rate is a whopping 0.2%. At a 10% discount that would mean market value of $2.5 Trillion (39% below current values) or with a discount rate of 6.2% we get the current market value

Case 2: Stable Growth at 4.7% (a figure I used in the previous post based on future population growth rates). This implies a retention ratio of 27% and free cash flow of about $182 Billion. At a 10% discount the market value is $3.6 Trillion (12% below current values) or with a 9.3% discount rate we get the current market value.

Case 3: Five year growth of 9.8% (computed from the estimated growth rates for the individual companies) followed by 4.7% stable growth. Using a 10% discount rate the market valuation is $4.2 Trillion - just about equal to the current value.

In summary the DJIA is currently fairly valued with the assumptions discount rate of about 10%, ROE of 17-18%, long term growth of 10% and short term (5 year) growth of 10%. If the DJIA companies achieve that, their aggregate profit margin will be just above 10%.

That does seem do-able, but a major issue to consider is the effect of global energy demand and supply. An imbalance could mean lower ROE's for most companies - including energy companies that will require massive investments in new energy sources or to extract from existing sources.