Dear Jim,

I haven’t much to add to my previous letter. If you had cast your original argument in terms of dividends rather than earnings, we would have had less to quarrel about. Even when you do cast it that way (in other words, when you put the right variable into your formula), you still conclude that the Dow should be higher–but now only 50 percent to 100 percent higher, not four times higher. That’s progress, I suppose.

A gap of 50 percent-100 percent between the actual and (you say) warranted levels of the Dow is still big, sure enough. Nonetheless, a difference of this order is explicable in terms of quite small changes in underlying assumptions. This is a consequence of adding up payouts to infinity–and a reminder to handle valuation formulas with care. Changes of mere tenths of a percentage point in your forecasts for inflation, dividend growth, and so on would close the gap between your “lower bound” dividend-based estimate of where the Dow should be and where the market actually is. (You use a real bond yield of 3.1 percent, for instance, in your calculation. But, as you say in your last letter, the real return on T bills is currently 3.7 percent. Using the second figure rather than the first would be enough to bring your estimate of where the Dow should be down to 9,000.)

So, once we are discussing lower bound dividend-based estimates, we are in the realm of difference of opinion and forecasting error. Our earlier discussion on the risk premium becomes relevant again. On all this we can agree to differ. But the enormous valuation anomaly you said you had spotted, the idea that attracted all the attention in the first place–the remarkable claim that the Dow should right now be at 36,000, on a price-to-earnings ratio of 100, and all that–comes not from tweaking the assumptions but from your conceptual breakthrough of an “upper bound” formula based on earnings. As I explained last time, that is not in fact a legitimate formula but a piece of nonsense, a plain mathematical absurdity.

What you say about Microsoft shows you still don’t see this, or won’t admit it anyway, but I can’t explain it more clearly than I already have. I advise readers who are still perplexed to look at Pages 59-62 of the current edition of *Principles of Corporate Finance*, by Brealey and Myers, a standard text. It explains how you use a discounted cash-flow formula (the simple formula, Jim, of your second letter) to value a stock. It explains why you must use dividends, not earnings, in such a calculation, and why it is a fallacy to suppose (as you do) that using dividends instead of earnings is equivalent to “ignoring” capital gains.

But what the hell, if the Dow hits 36,000 by the end of the year, lunch is on me.

Sincerely,

Clive