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Calculating the Dow Jones Industrial Average

Calculating the Dow Jones Industrial Average
The Dow moved 79 points today but what do these points represent We had a request to do a commentary on how the Dow is calculated so we will cover this topic tonight. 

The Dow is a priceweighted index. It was originally computed by hand more than 100 years ago by adding up the share price of each companies stock at the end of each day and dividing by the number of companies in the Dow.  That is why it was called the Dow Jones Industrial Average.  Over the years stock splits mergers spinoffs and other events resulted in changes in the divisor so now the divisor is a very small number (less than 0.2). 

History of the DJIA
Dow Jones & Co. was founded in 1882 by Charles Dow and Edward Jones.  The first averages did not even include any industrial stocks. The focus was on the growth stocks of the time mainly transportation companies. The first Dow Jones Index included nine railroad stocks a steamship line and a communications company. This average eventually evolved into the Transportation Index.  In 1896 the Dow split transportation and industrials into two different averages creating what we know now as the Dow Jones Industrial Average. To calculate the first average Charles Dow added up the stock prices and divided by eleven the number of stocks included in the original index. 

Today the DJIA is a benchmark that tracks American stocks that are considered to be the leaders of the economy. The DJIA is made up of 30 large cap companies which are subjectively picked by the editors of the Wall Street Journal. Over the years there have been many changes to ensure that the index stays current in its measure of the economy. The only company left in the Dow today from the original Dow is GE. 

Calculating the DJIA today is not as simple as adding up the stocks and dividing by 30.  For example if a company trading at $100 implemented a 2for1 split the number of its shares doubles and the price of each share becomes $50. This change in price would down the average even though there is no fundamental change in the stock. To absorb these effects of price changes from splits the DJIA has a divisor that is adjusted and then used when calculating the average. 

The Dow Divisor
To calculate the DJIA the current prices of the 30 stocks that make up the index are added and then divided by the Dow divisor which is constantly modified. 

For example let's say for simplicity The Dow is composed of 10 stocks which total $1000 when their stock prices are added together. The Dow quote is therefore 100.00 ($1000/10). The divisor is 10. 

Now let's say that one of the stocks in the Dow average trades at $100 but has a 2for1 split. Its price then reduces to $50. If the divisor remained unchanged the calculation for the average would give us 95.00 ($950/10). This would not be accurate because the stock split merely changed the price not the value of the company. To compensate for the effects of the split we have to adjust the divisor downward to 9.5. This way the index remains at 100.00 ($950/9.5) and more accurately reflects the value of the stocks in the average. 

How does a price move in one stock effect the Dow
To figure out how a change in any particular stock affects the amount the index changes up or down divide the stock's price change by the current divisor. For example if GE was up $2.00 today and the divisor is .2 (the divisor is less then .2 right now but for simplicity I will round it off) we divide 2 by 0.2 and come up with 10.00.  In this case GE is responsible for 10 of the 79 Dow points today. 

Price Weighted
The Dow's methodology of calculation is known as the priceweighted method. The downside to this method is that it does not reflect the fact that a $1.00 change in a $10 stock is a much more significant percentage change than a $1.00 change for a $100 stock.  Most all other major indexes such as the S&P 500 and NASDAQ are market cap weighted and in my opinion is much better.

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