Dow Jones Industrial Average

Posted by PITHOCRATES - May 6th, 2013

Economics 101

The Dow 30 is a Selection of Companies that gives an Idea of how the Economy is Doing as a Whole

The stock market rallied on Friday thanks to what investors viewed as a favorable jobs report.  Sending the Dow Jones Industrial Average into new territory.  Above 15,000.  But it couldn’t hold on to close above 15,000.  Instead, closing at 14,974.  Close but no cigar.  It even fell a little on Monday.  Reaching only 14,968.89 at the close of trading.

No doubt many wonder 14,968.89 of what?  Is it dollars?  After all, they call it the Dow Jones Industrial Average (i.e., the Dow).  And most know it has something to do with the stock prices of some group of companies.  Thirty, to be exact.  The Dow 30.  A selection of companies that gives an idea of how the economy is doing as a whole.  By looking at stock prices from all sectors of the economy.  So is the average price of these 30 stocks $14,968.89?  Well, let’s take a look at those 30 stocks and their closing prices at the end of trading today.

Bow Jones 30 Stocks and Closing Prices 5-6-2013

Hmmm.  Looks like IBM is the most expensive stock in the group at $202.78.  But an average can’t be higher than the highest price.  It has to be somewhere in the middle of the pack.  In this case the average is $64.97.  So the Dow certainly isn’t the average stock price of these 30 companies.   Is it the sum of these stock prices?  Well, if we add all of the stock prices in the above table we get $1,949.19.  That’s closer to 14,968.89 than 64.97.  But it sure isn’t 14,968.89.  So what exactly is this number?

A Company wants a Rising Stock Price and a High Trading Volume

The Dow Jones Industrial Average (DJIA) dates back to 1896.  Then it included 12 industrial stocks.  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 preferred and U.S. Rubber.  (General Electric has been a part of the DJIA for all its 117-year history except for the periods September 1898 – April 1899 and April 1901 – November 1907.)  And the DJIA was just that.  The average price of these 12 stocks.

To simplify this let’s look at three fictitious companies and their stock prices.  ABC at $300/share.  XYZ at $200/share.  And 123 at $100/share.  If you add these three stock prices together you get $600.  And if you divide this number by three you get the average stock price ($200).  This is how they calculated the first DJIA.  Only with those 12 stocks.  Which gave a good idea about the market.  If companies were doing well their stock prices went up.  Raising the average price.  Telling us the economy was doing well.  Doing this today, though, would give you a distorted view of the economy.  Why?  Because of stock splits (as well as the changing of companies in the Dow 30).

When a company has growing sales and growing profitability the value of the company increases.  Which the stock price reflects.  As people bid up the price of the stock.  Because everyone wants to buy it.  So the laws of supply and demand raise the price.  But a higher price will reduce the number of shares an investor can buy.  Which will reduce the trading volume.  Showing a falling interest in the stock.  Which may cause the stock price to fall.  Something a company doesn’t want.  What they want is a rising stock price AND a high trading volume.  Two seemingly contradictory things.  Which is where the stock split comes in.  Which works like this.  If there are 1 million shares outstanding at $300/share that’s a market capitalization of $300 billion (1 million shares X $300/share).  To increase the trading volume the company may announce a 2-1 stock split.  That is, they will cut the stock price in half and double the shares outstanding.  So after the stock split there’s a market capitalization of $300 billion (2 million shares X $150/share).  The value of the company is the same BEFORE and AFTER the stock split.  But the stock price is lower which encourages investors to buy and sell more of the stock.  Thus increasing the trading volume.  While the stock price can continue to rise.  Thus meeting those two contradictory objectives.

They divide the New Sum of the Closing Stock Prices for the Dow 30 by the Current Divisor to get the DJIA

The DJIA shows the relative strength of the economy.  As companies grow more valuable their stock prices rise.  If they rise a lot the company may announce a stock split.  Anyone holding stock at the time of the stock split will be very happy.  As the number of their shares may double.  Triple.  Even quadruple.  And even though the market capitalization remains the same before and after the stock split the split itself is a sign of a strong and growing company.  Which tends to drive the stock price—and the market capitalization—higher.  So stock splits are good things.  Which is why they had to change the way they calculated the DJIA.  For the average of stock prices after a split will fall even though the economy as a whole is getting stronger.  As we can see with our three sample companies.

Adjusting Index after Stock Split

This is the problem of using a straight average of stock prices.  It would show a weakening market when it was, in fact, growing stronger.  So they had to add a little math.  To make the market capitalization before and after the stock split the same.  And they do this with a divisor.  They divide the sum of stock prices after the split by the sum of stock prices before the split (450/600=0.75).  So if we divide the sum of stock prices after the split by 0.75 the ‘DJIA’ equals 600.  Just what it was before the stock split.  Which makes the market capitalization before and after the split the same.  As it should be between the close of one day’s trading and the beginning of the following day’s trading.  As there are more and more stock splits this divisor gets smaller.  As the sum of stock prices gets smaller with each stock split.  Which makes the divisor grow smaller with each stock split.  And as we divide the sum of closing stock prices in the Dow 30 by a divisor that is continually getting smaller the resultant ‘DJIA’ gets larger.  As we can see here.

Adjusting Index after Stock Split 2

These companies are doing exceptionally well.  So well that they all announced stock splits.  ABC and XYZ quadrupled the number of shares outstanding and divided their stock price by 4.  123 tripled their outstanding shares while dividing their stock price by 3.  The average stock price fell by 73%.  If this was reported as the ‘DJIA’ it would probably cause a stock market crash.  Which is why the DJIA is no longer an average of stock prices.  Because an average of stock prices does not show the true economic picture.  But adding a divisor into the mix does.  And every time there are stock splits (or new companies replace old companies in the Dow 30) they calculate a new divisor.  They divide the new sum by the old sum of stock prices.  Then multiply this number by the old divisor to get the new divisor.  Which they divide into the new sum of closing stock prices in the Dow 30 to arrive at the DJIA at the close of each trading day.

At the close of trading today the DJIA was 14,968.89.  While the sum total of the closing stock prices for the companies in the Dow 30 was $1,949.19.  If we divide 1,949.19 by 14,968.89 we get 0.130216081.  This is the divisor.  Which they publish every day.  Showing any revisions in the divisor whenever there is a stock split or a change in the companies in the Dow 30.  And every day at the close of trading they divide the new sum of the closing stock prices for those companies in the Dow 30 by the current divisor to get the DJIA.  And today they divided 1,949.19 by the current divisor to get 14,968.89.  The Dow Jones Industrial Average at the end of today’s trading.

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