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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 |
March 20th, 2008 at 9:31 pm
I see the value in using the P/E ratio to evaluate stocks, but I’m not so sure about applying it to an index. The companies are so diverse in size, industry, and many other factors. I suppose there’s some value in it, but I wouldn’t rely on it too much.
March 21st, 2008 at 7:38 am
The news a few days ago was that Goldman Sachs’ earning fell by nearly half to $5.12 billon from last year, and down by 26 percent from the fourth quarter,
Conservatively speaking, in a bear market, the earnings will be down about 30% and the P/E ratio will hit 12 or even 7. This gives estimated DJIA earnings of 654.6.
Now let’s project the new number for DJIA:
P/E Expected DJIA Level
7 4,582.2
8 5,236.8
9 5,891.4
10 6,546.0
11 7,200.6
12 7,855.2
13 8,509.8
14 9,164.4
15 9,819.0
I’d say DOW 7,200 is a good probability.
March 21st, 2008 at 8:40 am
I watch the DOW. Have over $100,000 invested through Edward Jones. Did well, Retained about $20,000 in the last three years. Would have gained $35,000 but family would not let me take it out at the right time, which was last March.
Now, it is invested in a safer environment through EJ still.
But, I have noticed that the DOW changes with the FED helping or some good report. A Lot of selling and and buying back and forth.
Yet, I believe that it is all a hot air balloon. If it is hot it rises…if it is cold it falls. But none of it is really based on real economical facts.
The housing market is cold for sure. Large companies are down sizing. People are being forced into early retirement. And there is a trend that I see and that is companies everywhere rethinking the amount of people that have hired. Lay off with a mind to stablize there company. Smart moves. But, it seems that no one is speaking of the trends only what the FED does…when that they are doing is not helping the average folks. Try to get a loan for a house. Even with excellent credit…they are not loaning on current down sized FED monies, but on their past borrowing. So, they still are charging high interest. I was lucky. I have a 4.75% on my house and only owe 10 years more.
March 21st, 2008 at 10:07 am
Wilson,
I would say there’s always that possibility, which would spell a good buying opportunity. I don’t see a P/E ratio in the mid-teens to be a good buying opportunity.
March 22nd, 2008 at 10:53 am
Great post. From a behavioral prospective, I think many investors look to P/E when allocating income. I feel that a couple good news stories could drive attention to the low P/Es and spark a nice rally. While 14,000 may be an aggressive goal, I am confident that the DOW will show some strength over the next 6 months.