Dow 18,500?

We [Morningstar] think the Dow Jones Industrial Average will rise more than 6,000 points to roughly 18,500 over the next three years.

How We Arrived at That Estimate
The Dow was trading at a very hefty 17% discount to our estimate of its fair value, which stood at around 14,000 as of Feb. 7, 2008. We base that fair value estimate on the fair value estimates that our equity analysts have placed on the Dow's 30 component stocks. The Dow hasn't looked this cheap to us since September 2002 when the index stood at 7,592 (three years later it had risen to 10,569).

When we take the Dow's market price and fair value estimate together with its 9.7% weighted average cost of equity (our analysts assign a percentage cost of equity to every stock they cover, including all of the Dow's components), it translates to a 17% annualized expected return. In other words, this is the return an investor would reap if the prices of the Dow's components converged to our fair value estimates over a three-year holding period (not ad infinitum).

To isolate the Dow's expected price return--which is what directly influences the index's value--we deducted the benchmark's 2.2% dividend yield from the 17% annualized return we derived. When we compound the Dow's closing value on Feb. 7 by this 14.8% annualized price return, we arrive at an 18,510 index value.