Dividend Discount Value Of DJII

Includes: DIA
by: Tony Hayes, CFA

In order to know where the DJII is going, it is of the utmost importance to know where the DJII is and, furthermore that value and price are not always the same. The value of the DJII measured by either the dividend discount model or the FED model has been at a premium to its price since Lehman and as such it should have been bought and should still be bought. Value will win out over time and investors should buy when price is below value and be patient while others drive through the rear-view mirror, climbing the wall of worry.

Why the DJII has gone up since March 2009 why it should continue:

As financial markets return to equilibrium, the yield on equities relative to the yield on 30-year T Bonds should decline from 64% back towards the historical average of 42% or even to the pre-Lehman 40%. Assuming no change in either the 30 year T Bond yields or the DJII dividends this would result in a 50% increase in the DJII price to 25,000. The Fed model points to a value of 32,500 and, given a return to a normalized payout ratio of 42%, so too would the dividend discount model.

Relative yields drive value. Price and value are the same 83% of the time.

Think of equities as perpetual bonds with variable coupons. By and large the equity coupons, or dividends, tend to rise over time. In the near term, bond yields play a more dominant role in the determination of relative value. In essence, changes in value are a direct function of changes in dividends and an inverse function of changes interest rates, (long bond yields).

Therefore, as dividends rise and 30-year T bond rates remain either flat or fall, the value of the DJII should rise. As price and value have had a correlation coefficient of 0.83 since 1981 and even higher, at 0.92, pre Lehman. There is, therefore, every reason to expect a continuation of this bull market in equities as fear and irrational pessimism dissipate.

Click to enlarge

Over the shorter time frame and on an arithmetic scale the wide spread between price and value is even more dramatic and compelling for value investors.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.