Understanding the Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average is perhaps the most widely followed stock market index in the world. Yet, very few people actually know what the number represents. In the time it takes to put on your shoes, you're about to become one of the rare people who knows what it means when you hear the nightly news.
The Birth of the Dow Jones Industrial Average
The Dow Jones Industrial Average was created by a man named Charles Dow, one of the founders of Dow Jones & Co., the same firm that gave birth to The Wall Street Journal. Its predecessor was born on February 16th, 1885, when Charles published a daily average of twelve stocks he had selected, originally consisting of two industrial companies and ten railroads. Within a few years, he had expanded the list to twenty stocks.
Four years later, Charles realized that industrial companies were quickly becoming more important than railroads. He adjusted the original index (on Wall Street, this process is known as “reconstituting”) and renamed it the Dow Jones Rail Average (in the 1970’s, the name was updated to the Dow Jones Transportation Average to cover the introduction of air freight and other forms of transportation). He then created a new index of stocks consisting of twelve companies and called it the Dow Jones Industrial Average or DJIA for short.
The process for calculating the reported figures for these new indices was the same: He added up the stock price of the companies he had chosen, divided by the number of companies in the index at the time, and published the result. The very first published Dow Jones Industrial Average figure was 40.94. In simple terms, it means that the average stock price of the twelve Mr. Dow had chosen was $40.94.
The Original 12 Stocks
The original twelve stocks in the Dow Jones Industrial Average consisted almost entirely of commodity-based firms and were as follows:
- American Cotton Oil
- American Sugar
- American Tobacco
- Chicago Gas
- Distilling & Cattle Feeding
- General Electric
- Laclede Gas
- National Lead
- North American
- Tennessee Coal & Iron
- U.S. Leather Pfd.
- U.S. Rubber
At the time, these were large, profitable, and highly respected firms. Most were eventually replaced in the Dow Jones Industrial Average, but according to Professor Jeremy Siegel, author of Stocks for the Long Run, all but one went on to have prosperous futures for shareholders. The exception was U.S. Leather Corp., which Siegel points out was liquidated in the 1950s. “Shareholders received $1.50 plus one share of Keta Oil & Gas; a firm acquired earlier. But in 1955, the president, Lowell Birrell, who later fled to Brazil to escape U.S. authorities, looted Keta’s assets.
Shares in U.S. Leather, which in 1909 was the seventh largest corporation in the United States, became worthless.” And you thought Enron was a modern invention!
Changes Over Time
In 1916, the Dow Jones Industrial Average was updated to include 20 stocks (known as “components”). By 1928, the DJIA was expanded to 30 stocks, which continues to be the rule today.
The editors of The Wall Street Journal decide which companies are included in the Dow Jones Industrial Average. There are no rules for inclusion, just a set of broad guidelines that require large, respected, substantial enterprises that represent a significant portion of the economic activity in the United States.
Where It Stands Today
As a result of the credit crisis and the “Great Recession” of 2007-2009, the Dow Jones Industrial Average underwent significant changes as companies failed, were merged, or simply dropped from the index. As of June 2009, the current thirty Dow components are:
- 3M Company
- American Express
- Bank of America
- Chevron Corp
- Exxon Mobil Corp.
- General Electric
- Hewlett-Packard Co.
- Intel Corporation
- Johnson & Johnson
- JP Morgan Chase
- Kraft Foods
- Merck & Co., Inc.
- Pfizer Inc.
- Home Depot
- Procter & Gamble
- United Technologies Corporation
- Walt Disney
The practical effect of this calculation was that a stock with a $100 share price would have five times the influence on the DJIA as one with a $20 share price (okay, not exactly, but you get the idea), even if the latter company had a market capitalization that was ten times as large! That’s why a company such as Berkshire Hathaway, which regularly trades at over $100,000 per share, couldn’t be added to the Dow without some sort of modification in the formula because it would instantly represent the entire index.
This flaw quickly became apparent when companies announced stock splits and other transactions that modified their nominal share price. A growing company, to make their shares affordable, may double their stock outstanding by splitting 2-1. Thus, an $80 stock would fall to $40, but there would be twice as many shares outstanding. Under the original calculation for the Dow Jones Industrial Average, this meaningless cosmetic change would result in the DJIA falling even if the stocks increased in value!
To compensate, the divisor of the DJIA is frequently modified for corporate events and transactions. Long story short, in the event of a stock split, the value of the Dow Jones Industrial Average is calculated both before and after the split. The post-split divisor is modified so that a change in the stock price of the company results in the same percentage change in the overall index as if the split had never happened.
According to the Wall Street Journal, the current divisor is 0.132319125. It means that a $1 move in a Dow stock will result in a move of 7.56 points in the Dow Jones Industrial Average.
Structurally, critics argue against the asinine practice of disregarding the overall size of a firm, focusing instead on a meaningless nominal value that can be modified through share repurchases or issuance. That is why you will often find professional money managers who instead use the S&P 500, which adjusts for overall market capitalization.