Television and radio business news reports lead with it almost daily. Serious financial discussions begin with it. Many economic discussions are often centered on it. The “it,” is the “Dow,” or more accurately, the Dow Jones Industrial Average, and it remains the most widely used measure of stock market performance by many main street pundits. So what exactly is the Dow Jones Industrial Average? The Dow is a price weighted “average” of some of the largest and well-known companies in the United States. But how the Dow is measured, its history, and current holdings are typically not so well-known. Let's take a brief look at market history, how the Dow has changed over time, and what the current companies that make up the Dow. Charles Henry Dow first devised his market “average” in 1884. The first “Dow” average consisted of 11 stocks, nine of which were railroads--the large growth companies of that era. Not surprisingly, not one railroad company remains in the index today. The Wall Street Journal first published the Dow in 1896, covering an average of 12 stocks. During the period from 1916 to 1928, the Dow average increased to 20 stocks and then in 1928, the now familiar 30-stock Industrial Average was born. All of the original names have disappeared after GE's removal in 2018; they have either merged, changed their name, been removed from the index, or gone out of business. If we were to use an example Dow of 28,000, it would mean that the average share price of the 30 Dow stocks is $28,000, and, of course, no Dow stock sells for anything close to that level. How then, do we make sense of this “average”? Here’s how it works. The Dow average is constantly adjusted for stock splits, stock dividends, and changes in market valuations of the component stocks. As an example, when a stock splits, the share price decreases and the number of shares increases proportionally, with total value to the shareholder unchanged. For example, a stock selling for $50 per share splits two-for-one. If you owned 100 shares, you now own 200 shares worth $25 per share. Overall, nothing has changed in terms of value. You’re probably now seeing that this function is going to impact the average price because even though the price of the shares came down the value of the company remained unchanged. So, this is what creates some complexity. While the impact of stock splits on individual investor holdings is straight forward, such changes in share price have an impact on the Dow. Consider the hypothetical Dow “average” of 28,000, and, on the same day, all of the stocks split two-for-one. If no adjustments were made to allow for the split, the Dow would “drop” to 14,000 overnight without any change in the underlying value. In order to compensate for these price changes which produce no effective change in total value, the Dow average is constantly adjusted by altering the “divisor” in the pricing formula. The divisor is simply that number when divided into the total share prices of the 30 component stocks, creates an equivalent basis on which to compare a current reading with any other historical reading since 1928. Each time a split occurs, the divisor must be adjusted downward; if this did not happen, the average share price of a Dow component stock (based on a Dow of 28,000) would really be $28,000. When the 30-stock Dow average was created in 1928, the divisor was 16.67. This number was derived to establish a price relationship to earlier averages so that historical comparisons would be meaningful. Over the years, the divisor has declined steadily, falling below 1.0 in 1986, at which time it effectively became a multiplier. (A quick review of the math will show the result of dividing a number by a number less than 1.0 becomes a larger number—that is, a divisor less than 1.0 effectively becomes a multiplier). The current multiplier is 0.152. So a $1 price move in any Dow component translates to a swing of 6.58 points to the Dow. While many financial professionals use other broader measures of market activity such as Standard & Poor’s 500 Index (the S&P 500) or the Russell 2000, the Dow is still considered a reflection of the overall stock market is a testimony to how powerfully ingrained the Dow is to our collective thoughts. Below is the current list of what makes up the Dow Jones Industrial Average, along with recent market values for each company along with their respective 5-year total return. -Paul R. Rossi, CFA
0 Comments
Your comment will be posted after it is approved.
Leave a Reply. |
AuthorPaul R. Rossi, CFA Past Articles
April 2022
|