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An Exercise in Futility - Estimating the Future of the Dow Jones Industrial Average
By JLP | March 20, 2008
Most of us know what a Price/Earnings Ratio is. If not, I’ll refresh your memory. The P/E formula looks like this:
Basically, the P/E Ratio is a number that represents how much investors are paying for $1.00 of company earnings. So, if a stock has a P/E of 30, investors are essentially paying $30 for each $1.00 of earnings. The higher the P/E Ratio, the more optimistic the outlook is for the company’s future.
If we know that P/E Ratio and can estimate the Earnings Per Share, we can estimate what the stock price should be (it’s not an exact science). For example, let’s say a stock usually has a P/E Ratio of 12 and you expect the company will earn $3.00 per share this year. You can make a rough estimate of where the stock should be trading by altering the P/E Ratio formula:
Of course there’s a lot more that goes into estimating stock prices than just looking at the P/E Ratios. For one, the earnings estimates could be wrong (and they usually are). The economic outlook could always change. If the outlook becomes pessimistic, P/E Ratios across the board could drop, which would have a negative impact on stocks.
Applying P/E Ratios to an Index
We can also use this same logic with an index like the Dow Jones Industrial Average (DJIA). Let’s say we want to estimate where should be trading at the end of 2008 based on this year’s expected earnings per share for 30 companies in the index. To figure this, we need the earnings estimates for the 30 stocks. I found these estimates on the Value Line website and put them into an Excel spreadsheet:
In order to get the earnings estimates for the entire DJIA, you simply sum the earnings estimates for the 30 companies and divide that number by the DJIA divisor (0.122834016). So, using Value Line’s estimates, the expected earnings for the DJIA for 2008 is $935.16.
Now, where can we expect the DJIA to trade based on those earnings estimates. Well, it’s anybody’s guess, but one thing you can do is plug in different P/E Ratios and see what you come up with. I’ve done it for you with this handy little graphic:
So, if the historical P/E Ratio for the DJIA is 15 (I have no idea what the average P/E Ratio is for the DJIA), we can expect it to trade around 14,000.
Like I said earlier, this is not an exact science because there are so many other factors that influence stock prices. But, it’s still fun to look at and it makes for an interesting way to use P/E Ratios.
Topics: Investing |