How is the Dow Calculated?

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Recently, Travelers and Cisco replaced GM and Citigroup as part of the Dow Jones Industrial Average Index (DJIA). When it became clear that GM and Citigroup’s days on the Dow were numbered, people began speculating which companies would take their place. Because there are no set rules on what companies will make up the Dow, the speculation mounted until the decision was made. Add to that the absence of big companies like Berkshire Hathaway and Google from the Dow, and one naturally has to wonder how the companies that make up the storied Dow Jones Industrial Average are chosen.

So let’s take a look at the Dow Jones, beginning with its founding in the 19th century.

History of the Dow Jones

The very first index was published in 1884 and consisted of 9 railroad companies and two industrials. It was founded by Charles Dow, who was the co- founder of the Dow Jones & Company and an editor of the Wall Street Journal.

12 years later, on May 26, 1896, the index was broadened and split into Dow Jones Industrial Average and Dow Jones Transportation Averages. The Dow Jones Industrial Average (DJIA) stood at 40.96 and consisted of 12 stocks. Of the initial 12 companies, GE is the only company still in the index.

Who Selects Companies to Include in the Dow

The DJIA is comprised of companies selected by the editors of The Wall Street Journal. They use their judgment to decide which stocks should be included in the index to best reflect the market. And they decided Travelers and Cisco would better reflect the market than GM and Citigroup. The editors try to keep the index composition in such a manner that it gives a good representation of all the sectors in the economy in their relative importance to the economy.

For example, when the technology sector came to the forefront in the late 90’s, the Dow Jones added Intel and Microsoft to the index. But they don’t have a fixed schedule of review and only change the index components when they feel a change is necessary to better reflect the total market.

How is the Dow Jones Industrial Average Calculated?

We have historical data on the DJIA all the way back to May 26, 1896. At that time, the index was comprised of 12 stocks and the calculation was very simple. They added the price of all 12 stocks, divided it by 12 and voila – your index was ready. It’s as simple as that. Take the price of all the stocks and divide it by the total number of stocks in the index. In this way, the DJIA is unlike most stock indexes.

Unlike the S&P 500, for example, the Dow Jones Industrial Average is based on simple price averages and not market capitalization. As a result, Disney and American Express, both of which trade for about 25 dollars, will have the same impact on the movement of the DJIA, even though Disney has a market cap of about 46 billion dollars, while American Express stands at about 29 billion dollars.

And this explains why the Dow will never include the likes of Berkshire Hathaway or Google in the index. Because these stocks are very expensive on a per share basis (Berkshire A at $89,050; Google at $417), including them in the Dow would skew the average in favor of Berkshire and Google. In effect, the Dow would become the Berkshire/Google index.

Over the years, the core methodology hasn’t changed much, but they have made provisions so that stock splits and dividends don’t impact the calculation of the index. And that brings us to the DJIA Divisor

DJIA Divisor

They use a “Divisor” to take care of stock splits and dividends. The divisor is a number that smoothes out the impact of stock splits and dividends which impact the price of the stock. If a stock is split in two, for example, its price comes down by about half. That means it loses half of its impact on the index even though there hasn’t been any real change in the value of the stock.

The divisor is the number that the stock price is divided by, so, when the index was started with 12 stocks, the divisor was 12. So, you sum up the stock prices of all 12 stocks and then divide it by 12.

When it was first published the Divisor was 12 and the value of the index was 40.94. If you summed up the price of the 12 stocks, you got 491.28 and dividing that by 12, you got 40.94, which was the index value.

Suppose, one stock in this index is 40 dollars and it is split into two. So instead of a sum of 491.28, you will only have a sum of 471.28 (491.28 – 20) and if you divide it by 12, the index value is just 39.27. So, the index has fallen, even though the value of the underlying
stocks has not changed at all.

To take care of this problem the divisor was invented. The divisor is a number that will give you the exact index value as it were, if the stock split or dividend didn’t come into effect. If you divide 471.28 by 11.51, you will get 40.94, which was the original index value. So our divisor is now 11.51, instead of 12.

To find out the divisor, you need to take the new sum of stock prices and divide it by the old index value. In our case – (471.28 / 40.94) = 11.51

And (471.28 / 11.51) = 40.94 (same as before).

Conclusion

The way the DJI is constituted means that the editors will never be able to pick stocks that trade much higher than the current market price of its stocks. So, for that reason – Berkshire Hathaway which has a market cap of 142 billion dollars will never enter this index and Google with a price of about 420 dollars and a market cap of 135 billion dollars will also find it difficult to enter the index. Other than that, the DJI is a really old index and people are just used to it. For that reason it will continue to remain a much tracked and really popular index for years to come.

Our guest post today is courtesy of Manshu Verma from OneMint, a website with the vision of “creating wealth for everyone”. If you liked this article and wish to read more about the economy, stocks, investing, credit cards or other topics on personal finance, please consider subscribing to this feed.

Published or Updated: June 19, 2009

Comments

  1. Manshu says:

    Thanks to DR for letting me guest post here!

  2. Finance Nerd says:

    Just to clarify one statement, the DJIA divisor is NOT adjusted for “normal” dividends, but it is adjusted for special (i.e. large) dividends.

    Source: http://www.djaverages.com/?view=question&page=faq#a6

    A 2000 Stanford University study showed that the DOW would have been at 250,000 if dividend reinvestment had been included in the index. Of course the Dow is down since then, but the value with dividend reinvestment would still be well over 100,000.

    Source: http://www-siepr.stanford.edu/papers/pdf/99-16.pdf

  3. gfred says:

    Great post – can’t wait to read your next one!

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