By ADAM BARTH, Barron's, JULY 11, 2005
The Dow has averaged an 11% return on equity over nearly 75 years. Everything else – earnings included; is just noise.
Examine the Dow's annual return on equity for each 20-year period since 1920 (that is, 1920 through 1939, 1921 through 1940, and so on): Average earnings as a function of book value barely varies in the slightest, and has remained basically immune to inflation, wars, massive changes in the tax code or any other external factor.
For the 34 consecutive 20-year stretches between 1934-1953 and 1967-1986, the return fell in an incredibly narrow range of 10.5% to 11.6% -- or an average of around 11%. Furthermore, the Dow's book-value growth rate has remained near its 4.8% historical average from 1920 to 2003 for every 20-year period on record.
Finding the Dow's normalized earnings in any given year is as simple as multiplying 11% by the Dow's book value at the time. These earnings will grow at a little under 5% per year -- the Dow's steady and predictable 20-year book-value expansion rate.
While earnings gyrate from year to year, the Dow's earnings over the coming 20 years or any 20 years is virtually preordained.
The 11% solution demonstrates why this is so. Of the Dow's 11% ROE, 5% has consistently been retained -- thus allowing the Dow's 5% earnings-growth rate. The remaining 6% has been free cash flow available for distribution to shareholders in the form of dividends and stock buybacks. As such, the Dow is a perpetuity that can be easily valued by dividing its current free cash flow (6% of current book value) by its expected rate of return minus its long-term growth rate (9% minus 5%).
With the Dow's current book value a little under 3000, its normalized free cash flow is roughly 180. Dividing 180 by an expected return of 9% minus free cash flow growth of 5% (.09 - .05) yields a valuation for the Dow of 4500, less than half of its current market valuation. To justify a Dow value of 10,500, one has to lower the future expected investment return for the Dow to 6.7%.
From 1920 to 2003, Moody's Aaa corporate-bond yield averaged 5.9%. Recently, Barron's Best Grade Index has shown a current yield of 5.24% for top-grade corporate bonds. Assuming a forward rate of return of 6.7% for the Dow would imply an equity-risk premium of just 0.8% to 1.5%.
A normalized 20 P/E ratio for the Dow would imply a normalized 18% return on equity (5% earnings yield x 3.6 book value multiple = 18%). While the Dow averaged an 18% return on equity over the prior decade, assuming a lasting return on equity anywhere near this figure is absurd, given the historical record.
Putting history aside, basic logic alone dictates that a sustained 18% ROE is impossible. A return of this magnitude would mean that American business as a whole is capable of lasting, monopoly-type profits. The truth is the exact opposite: Big Business' profit growth has consistently trailed broad economic expansion, with nominal GDP growth increasing at a 7% rate and Dow profit growth lagging behind, at near 5%, for nearly every 20-year period on record.
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