How Much Lower Growth Is Priced Into the Dow?

 |  About: SPDR Dow Jones Industrial Average ETF (DIA)
by: Michael Parmar

On April 29, the Dow (NYSEARCA:DIA) closed at 12810.54. Yesterday, just 28 trading days later, it was 5.6% lower. This was largely due to changed expectations of lower growth relating to wider economic conditions and their impact on the 30 Dow companies.

Using the Dow company closing prices, current earnings P/E, 1 year forecast P/E (current closing price/next year’s forecast earnings) and Dow weighting, a bottom up calculation was made to estimate some simple metrics for the Dow and to calculate how much lower growth was priced into the 5.6% decline in index value.

At yesterdays’ close, the Dow’s current year P/E ratio is calculated to be 13.75; using year- ahead forecast earnings, the P/E comes out at 11.17. At closing prices on April 29, the Dow current year P/E stood at 14.53 and year ahead P/E stood at 11.81. Compared with yesterday’s close, these calculations suggest the market has shortened its payback expectations by 8 months with the 5.6% drop in prices.

EPS is 7.3% of the value of equity (yesterday’s closing price). Year-ahead forecast earnings are 23% higher, at 8.9% of yesterday’s closing price. It is worth noting that only 3 out of the 30 companies had lower forecast earnings next year compared with current year: Coca Cola (NYSE:KO), Travellers (NYSE:TRV) and AT&T (NYSE:T). Only one company, Bank of America (NYSE:BAC) - with the lowest weighting in the Dow at 0.6648% - had no positive current year earnings but is forecasting earnings for next year.

Using the Dow historical range of 14 -16 P/E and assuming next year’s forecast earnings are all met, the Dow should be trading between 25% and 43% higher than yesterday’s close, or in rough terms between 1500 and 1700.

Of course P/E ratios are only a rough and ready guide to valuations, and as those numbers suggest, lead to some surprising and possibly dubious conclusions. History is not a guide to the future.

Share prices (and hence the Dow index) are meant to reflect the present value of appropriately discounted expected future earnings adjusted for growth. This approach can be used to calculate the change in expectations related to growth in forecast earnings under certain assumptions, which can serve as a benchmark to question whether the implied price or indeed implied change in growth expectations is “too much” or “too little.”
The simple dividend growth model serves as the tool, in which the share price represents the present value of a dividend stream discounted by the appropriate rate of return after adjusting for annualised growth in earnings. According to the model, as long as the market’s required rate of return from the Dow and published earnings guidance of each company didn’t change since April 29, any change in index value would reflect the revised expectations of future earnings growth.
The change in growth expectations implied by a 5.6% drop in the Dow is -0.47%. In other words, the drop in the Dow implies forecast earnings are expected to be around 0.5% lower per year going forward, relative to expectations held on April 29.
The reasonableness of this estimate can be put into context using the table below:
Growth adjustment
Value of the Dow
Click to enlarge
If you believe that growth in forecast earnings for the 30 Dow companies is unchanged since April 29, then the growth adjustment to apply is 0% and the value of the Dow should be where it was on that day: 12810.54.
If on the other hand you feel that recent economic events would have the equivalent effect of lowering future earnings growth for the Dow companies by 2% per year, expecting the Dow to head to 7434 in the not too distant future would not be unreasonable.

In terms of growth related to this year alone, recall that next year’s forecast return for the Dow is about 9%. If this is reduced by half to 4.5%, and in subsequent years the Dow returns to 9% EPS, this single year loss approximately equates to losing 0.1% annualised earnings growth when discounted at 9%. At such a value, the Dow index would trade at 12660.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.