How Is the Value of the Dow Determined?

The Dow reflects price changes in the stock market.

The Dow Jones Industrial Average or DJIA is the oldest and most widely followed of the U.S. stock market indexes. The Dow is composed of the stocks of 30 major companies in the U.S., as determined by the Dow Jones Co. The value of the Dow is based on the stock prices of those 30 companies.

History

The DJIA was created in 1896 by Charles Dow and at that time included 12 stocks. The index value determination was truly an average in the mathematical sense. Dow added up the stock price of the 12 stocks and divided by 12. The value of the first calculation was 40.94. The number of stocks in the average reached the current 30, not long before the 1929 stock market crash. The record high close for the Dow Jones Industrial Average was 14,164.63, set on Oct. 9, 2007.

Considerations

After the DJIA was in use for about 30 years, it was determined that a simple average of the stock prices would not provide an accurate picture of the changes in value of the overall market. If a company had a stock split, the overall market value of the company would stay the same, but the stock price would decrease after the split, lowering the value of the index without a corresponding change in the value of the market. Also, over the years the stocks of different companies were added and dropped from the index to maintain its status as the premier stock market index. When General Motors was removed from the index in June 2009, the almost worthless GM stock was replaced by Cisco, which had a share value of about $20 per share.

Function

The Dow Jones Industrial Average now uses an adjustable divisor to remove non-market-based price changes from the value of the average. The divisor was first used in 1928, and each time a stock was changed, split or paid a dividend, the divisor was adjusted to reflect the change. Now the value of the DJIA is determined by adding up the stock prices of the 30 stocks in the average and dividing the total by the current divisor. In March 2010, the DJIA divisor was 0.132319125.

Effects

The Dow is a price-weighted index. This means the same percentage price change in a more expensive stock such as IBM at almost $130 per share has almost 10 times the effect of a price change in Alcoa at $14 per share. The other side of the price-weighted method is that a $1 change in Alcoa has the same effect on the average value as a $1 change in IBM.

Significance

For investors, the price-weighted valuation method of the Dow Jones Industrial Average sometimes gives too much clout to price changes in a few high priced stocks. Other indexes such as the S&P 500 and Nasdaq Composite are market-capitalization weighted. These indexes more accurately reflect the changes in the value of the total stock market. On days where the Dow moves in one direction and the other indexes in the other, for the overall market, the Dow is the odd man out in regards to the true U.S. stock market value.

References

• Dow Jones Averages: Dow Jones Industrial Average