Question

Q20: Dow Jones Industrial Index has reached historical high recently. What factors in the stock valuation model have driven the stock market index to the historical high level?

Answer 1

The Dow Jones Industrial Index is just a composite (a price-weighted average) of its 30 constituent stocks. Hence, any up-move in stocks, on an aggregate basis, drives up the index. There are different stock valuation techniques - like DCF (Discount Cash Flows) and Relative Valuation. Let's use DCF for our explanation. The DCF price of a stock is directly related to the free cash flows of a company and it's expected growth rate. Further, the price is inversely related to the cost of capital for the company.

Since the Global Financial Crisis of 2008, the US economy has seen its longest expansion in history till date. Companies are doing well, especially in the aftermath of the corporate tax cuts announced by the Trump government. The general sentiment is optimistic and, hence, expected future growth rates are high. At the same time, the cost of capital has been low because of prolonged Quantitative Easing by the Fed after the GFC.

Thus, we see how the three main drivers (viz., free cash flow, growth rate and cost of capital) of the DCF price of a stock have been favourable in recent years. This explains the performance of the DJIA.