how is the Dow Jones calculated

How is the Dow Jones Calculated?

The Dow Jones Industrial Average (DJIA) is the second oldest and one of the most well-known stock market indices. It is used as a measure of stock market performance. If it rises, people think the stock market and economy are performing well, and vice-versa.

When first created, 12 stocks existed in the index. Today, the number is set at 30. The value of the Dow fluctuates daily because of the price movement of the constituent stocks. However, the Dow Jones Industrial Average value is not simple to understand, but we will show how it is calculated in this article.


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What is the Dow Jones Industrial Average?

The DJIA is also referred to as the Dow 30 because it consists of 30 large American companies trading on the New York Stock Exchange (NYSE) and Nasdaq. The stocks have market capitalizations in the tens to hundreds of billions of dollars. A few have a market cap of over $1 trillion.

The Dow Jones calculation is based on the daily share prices of the 30 component stocks and the Dow Divisor. Hence, the index is price-weighted, unlike the S&P 500 Index, which is market capitalization-weighted. As a result, companies with a higher price will have a greater impact than those with a lower price for a similar percentage change.

Equities in the index are known as blue-chip stocks since they have excellent reputations, a long track record of dependable earnings, and typically pay dividends to investors.

The Dow Jones components with the highest yield at the end of each calendar year are known as the Dogs of the Dow in the upcoming year.

History of Dow 

The Dow Jones Industrial Average is the second oldest index after the Transportation Average. It was created by Charles Dow and his business partner Edward Jones on May 26, 1896. The number of companies was initially set at 12 but later expanded to 20 in 1916.

In 1928, Peter Hamilton, the editor of the Wall Street Journal, redid the index, replacing six stocks and increasing the number to 30. He also changed how stock splits were handled. As a result, when the Dow Jones was calculated, the Dow Divisor was changed proportionally to maintain continuity.

The index has evolved over time. In the early years, it contained mostly Industrial sector stocks. Today, the Dow 30 covers more sectors but excludes Utilities and Real Estate. Additionally, it does not include transportation companies.

The S&P Dow Jones Indices maintains the index.

How is the Dow Jones Industrial Average Calculated

When the Dow Jones was first calculated, it was a simple price average because the sum of the 12 closing share prices was divided by the number of components.

This method worked well for a short time but proved impractical. Individual equity actions like stock splits and dividend payments caused problems. In addition, structural changes, like when the number constituents were increased or decreased, caused more complications.

Problems With the Original Dow Jones Calculation Method

One problem with the original method was that an addition or deletion to the index caused significant changes to the value. For example, if hypothetically two stocks were in the index priced at $25 and $75 per share, the average is $50. However, if a third stock was added to the index at $10 per share, the average price is now $36.67, a large change not reflective of the market’s action or the economy’s health.

A similar difficulty happens when a stock splits; the number of shares increases, and the price is reduced to maintain the same market capitalization. For instance, if company XYZ has a stock price of $90 and conducts a 3-to-1 split, the stock price is now $30, but the share volume has tripled. The market capitalization remains constant. However, in a price average calculation, the stock price is now $30, causing a drop in the Dow’s value.

Lastly, an analogous problem occurs during a spinoff or when a dividend is paid, which can cause a sudden jump or drop in the DJIA value.

The primary issue is a price average method does not account for maintaining a constant market capitalization. Asa result, the above problems all require the denominator to change for continuity.

Current Dow Jones Calculation Method

The Dow Divisor concept was employed in the denominator to maintain a constant index value and prevent significant fluctuations. Changes in the DJIA require the following equation to be true:

\( Dow~Jones~Value = {\sum{P^i_{old}} \over D_{old}} = {\sum{P^i_{new}} \over D_{new}}\\\)
\( {P^i_{old}} = {Sum~of~Old~Dow~Stock~Prices}\\\)
\( {P^i_{new}} = {Sum~of~New~Dow~Stock~Prices}\\\)
\( {D_{old}} = {Old~Dow~Divisor}\\\)
\( {D_{new}} = {New~Dow~Divisor}\\\)

Consequently, when the Dow has a structural change or a corporate action affects it, the divisor is adjusted so the index value is uniform and continuous. In effect, the Dow Divisor normalizes the Dow Jones calculation.

As of August 2023, the divisor for the DJIA was 0.15172752595384. The quantity last changed when International Business Machines (IBM) divested Kyndryl (KD) on November 4, 2021.

The Bottom Line About How the Dow Jones is Calculated

The Dow Jones is one of the oldest and most recognized indices. It tracks 30 blue-chip companies in America. Investors look at the DJIA value to assess how the market and the United States economy are performing. However, it is crucial to understand how the Dow Jones Industrial Average is calculated and its limitations.

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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.

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