Understanding the Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA) is perhaps the most widely followed stock market index in the world. Yet, very few people know that the number represents just 30 firms.
The Birth of the DJIA
The Dow Jones Industrial Average got its start on May 26, 1896. The Dow was created by a man named Charles H. Dow, one of the founders of Dow Jones & Company (formed in 1882).
Dow's first index was created in 1884. It had 11 transportation-related stocks. He changed the original index (on Wall Street, this process is known as “reconstituting”) and renamed it the Dow Jones Rail Average. In the 1970s, the name was updated to the Dow Jones Transportation Average to cover air freight and other forms of transport.
Dow soon found that industrial firms were rising more quickly in value than railroads. He then made a new index using the stocks of twelve companies. He called it the Dow Jones Industrial Average (DJIA for short). The index was first made up of industrial companies, such as those in the cotton, sugar, tobacco, and gas sectors.
To calculate the index figure, Dow added up all of the stock prices. He then divided it by the number of companies in the index at the time.
The very first DJIA was 40.94. This meant that the average stock price of the twelve stocks Mr. Dow had chosen was $40.94.
The Original 12 Dow Jones Stocks
The original twelve stocks in the DJIA were almost entirely commodity firms and were as follows:
American Cotton Oil Company
American Sugar Company
American Tobacco Company
Chicago Gas Company
Distilling & Cattle Feeding Company
Laclede Gas Company
National Lead Company
North American Utility Company
Tennessee Coal & Iron
U.S. Leather Company (Preferred)
U.S. Rubber Company
At the time, these were large, profitable, and highly valued firms. Most were replaced in the DJIA as their stock prices fell or they went out of business.
Changes Over Time
In 1916, the DJIA was updated to include 20 stocks. By 1928, it grew to 30. This is still the rule today.
There are no rules for Dow inclusion. There is only a broad guide that requires large, respected, and substantial firms with high stock prices. In general, these firms represent a large portion of the economic activity in the United States.
Which Companies Are in the Dow Today?
The most recent update to the index took effect on August 31, 2020. Amgen, Honeywell, and Salesforce were added, while ExxonMobil, Pfizer, and Raytheon were cut. The 30 Dow companies are now:
Walt Disney Co.
Travelers Cos. Inc.
Procter & Gamble Co.
Visa Inc. Cl A
Cisco Systems Inc.
Johnson & Johnson
American Express Co.
International Business Machines Corp.
Walgreens Boots Alliance Inc.
Home Depot Inc.
Goldman Sachs Group Inc.
Merck & Co. Inc.
Honeywell International Inc.
Nike Inc. Cl B
JPMorgan Chase & Co.
UnitedHealth Group Inc.
Verizon Communications Inc.
Criticisms of the DJIA
The practical effect of Dow's 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, even if the firm had a market capitalization that was 10 times as large.
That’s why a company such as Berkshire Hathaway (BRK/A), which has traded for over $200,000 per share since mid-2016, couldn’t be added to the Dow without some modification in the formula; it would inflate the entire index.
This flaw quickly became known when companies announced stock splits and other transactions that modified their nominal share prices. To make their shares more affordable, a growing company may double its number of outstanding shares by splitting them 2 to 1.
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 cosmetic change would result in the DJIA falling even if the stock were to increase in value.
To compensate, the divisor of the DJIA is often changed for corporate events and stock actions, such as special dividends and stock splits. As a result, many money managers use the S&P 500 or other indexes that adjust for a firm's market capitalization.
The Bottom Line
The Dow Jones Industrial Average has changed quite a bit over the past 100 years and will keep changing as the economy shifts. While it isn't the broadest measure of economic health, the Dow's history and makeup can help you decipher a common financial term.
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Article originally appeared on thebalance.com
Credit: thebalance.com, NYSE, DJIA
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