Learn more about how the Dow divisor works, why some people think it understates the performance of Dow constituent companies, and what this means for individual investors.
Definition and Example of the Dow Divisor
The Dow Jones Industrial Average was introduced in May 1896. The Dow was originally the daily average share price of 12 industrial companies selected by Wall Street Journal co-founder Charles Dow to represent the sectors of the U.S. economy. The original average started at 40.94. Since 1928, the Dow has been composed of 30 companies. The last of the original 12 Dow companies, General Electric, was removed in 2018. The Dow is price-weighted, however. Companies that have a higher share price have a greater impact on the average than do companies with lower share prices. Changes in Apple stock at $177.34 a share have a much greater impact on the Dow than do changes in Coca-Cola at $57.57. When a stock splits, like Apple’s on a 4-to-1 basis in August 2020, the impact on the Dow can be dramatic. As a result of this split, Apple’s share price dropped to about $125 from nearly $500 in one day. So the Dow divisor is used to maintain consistency in the average and to adjust for stock splits, stock dividends, additions, and deletions of companies, as well as other changes. The Dow divisor changes regularly and is maintained by the S&P Dow Jones Indices division of S&P Global.
How the Dow Divisor Works
When the Dow was introduced, the share price of each of the 12 companies was totaled and divided by 12, which was the original divisor. Stock splits were handled by “weighting” a company’s share price according to the split. If Dow constituent Company A had a share price of $10 and split 2-for-1 to $5 a share, the share price of Company A would be counted twice. This method, of course, became difficult to maintain as the Dow grew to 30 companies. In 1928, a new method was introduced to handle splits that adjusted the divisor, rather than weighting the share price. The divisor is adjusted so that the average after the split equals the average prior to the split. Here’s an example using three companies: A, B, and C: Company A’s price pre-split is $10. Company B’s price pre-split is $20. Company C’s price pre-split is $30. Hence, their pre-split average is $20: (A + B + C)/3 = $20 Then Company C executes a 2-for-1 stock split. Company A’s price post-split remains $10. Company B’s post-split price stays at $20. But Company C’s share price post-split on a 2-for-1 basis becomes $15. So the post-split divisor changes to 2.25, rather than 3: (A+B+C)/20 = 2.25, while the post-split stock price average remains $20: ($10 + $20 + $15)/2.25.
Criticism of the Dow Divisor
Understating Performance
The Dow divisor calculation method results in understating compared share-price performance and may not well represent the U.S. stock market as a whole. Let’s look at what happens in our example if Company C’s stock rises to $20 after the split. Average = $10 + $20 + $20/2.25 = $22.22 If we used the old method of weighting the price pre-split, here’s the result: Average = $10 + 20+ ($20 x 2)/3 = $23.33
Inconsistent Treatment of Stock Dividends
Stock dividends are similar to stock splits. Instead of a cash dividend, shareholders are awarded additional shares of stock. A shareholder who owns 100 shares of a stock would receive five additional shares of that stock in a 5% declared stock dividend.
What It Means For Individual Investors
At the end of each trading day, analysts will often discuss which of the Dow 30 companies affected the DJIA. Investors can calculate the effect of a company’s share price change by dividing the increase or decrease by the divisor. For example, if Apple stock rises 10 points and the divisor is 0.15172752595384, then Apple stock accounted for about 66 points of the change in the Dow. The divisor is published daily in The Wall Street Journal and Barron’s.
