If you're a fan of the Dow Jones Industrial Average, then you know that it's been awhile since it crossed a major milestone. In fact, on May 6, 2006, it had been seven years since the Dow first passed the 11,000 mark.
Update to the Dow at 12,000
On October 19, 2006, the Dow finally crossed the 12,000 mark roughly seven years and five months after reaching 11,000. Below is an article written using the tools and techniques described elsewhere on this website. While our prediction of June 2007 did not come true, the techniques described in this article still serve as a useful example of the thought process an analyst should go through when solving this type of problem.
Predicting the Dow at 12,000
Before we get to the prediction of when the Dow will pass the 12,000 mark, let's briefly discuss what we're not going to talk about. We're not going to discuss momentum or charting in our version of the Dow at 12,000. Our prediction is going to be made based on fundamental data: earnings per share, P/E ratios, and growth in earnings.
In fact, the prediction we're going to share isn't really even ours. We're going to leverage the information that stock analysts and industry experts publish to the marketplace to figure out when they believe the Dow is going to pass the 12,000 mark.
The Dow Jones Industrial Average
Calculating the DJIA is very straightforward. Only three bits of data are needed to do the calculation:
The DJIA is calculated by multiplying each of the stock prices times the DJIA Divisor and summing the results.
The Dow Jones Divisor
The Dow Jones Divisor is a mechanism used to preserve the historical trending of the averages. When it was first developed, the DJIA was computed by adding up all of the prices of the underlying stocks. This method worked well until stock splits began occurring or when the components themselves started to change.
The Divisor was developed to normalize for stock splits and companies that entered and exited the DJIA. Each time a stock in the Dow splits, or a new company is introduced into the average, the Divisor changes. By introducing a Divisor into the calculation, the DJIA could make each transition smoother, and more meaningful, by preserving the numerical history of the Dow.
Once we grabbed our list of the companies making up the Dow, we pulled the earnings estimates the analysts made for year-end 2006. We also wanted to know what the earnings growth rate was for next year - 2007. By using these two values, we could derive the earnings estimates for both 2006 and 2007.
This information, along with the forward P/E ratio for each company appears in the table below:
DJIA Earning Estimates and Forward P/E Ratio
If we want to predict the future price of a stock, we need to multiply the future earnings per share by the P/E ratio. In this example, we are using the forward P/E because this is where analysts think the P/E ratio for each company will be a year from now.
Finally, if we take those projected stock prices and divide by the Dow Divisor, then we can see each company's contribution to the Dow Jones Industrial Average. By adding that information together, we can see where the analysts think the Dow is heading.
DJIA Future Stock Prices and Contributions
The Dow Jones Divisor at the time of writing was 0.12493117. To develop this prediction we also had to make one slight adjustment to the General Motors information. Because their EPS was negative in 2006, this throws the forward P/E ratio out of whack. We substituted their 5-year average P/E ratio to compute their stock price in 2007.
Individuals interested in learning more about some of the terms used in this calculation are encouraged to read the topic: understanding financial ratios.
When Will the Dow Hit 12,000?
We turned to the experts for their opinions and estimates to answer this question. Anyone thinking the Dow is going to hit 12,000 in 2006 is in the minority. The analysts predict very little movement in the Dow.
According to the experts, the Dow is going to hit 12,490 by year end in 2007. A reasonable guess is June 2007. We think this method is as realistic, and accurate, as any other we've seen published.
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