Yes, Apple is Going in the Dow; But Do You Remember How the Dow is Calculated?

It will be big news when Apple, Inc. is embraced by the Dow Jones Industrial Average on March 19th. Some might be surprised to find such a significant company was not already included in the statistic. Upon hearing the news I tried to remember exactly what companies are in the Dow, how it is calculated and what the history is. I’ve been over this plenty of times in school however it’s not something you think about everyday. I thought I might not be the only one in need of a refresher so I will look into these questions here.

What It Is
The Dow Jones Industrial Average is a statistic based on the stock prices of 30 of the largest US companies. The companies included are purposefully selected in order to cover the most significant and highly trades companies in all major industries of the US economy except Transportation & Utilities, as those industries have their own Averages. The Dow is one of many averages or indices available today. Some others include the S&P 500 & The Russell 2000, along with many foreign averages such as the Nikkei 225 in Japan.

There is no mathematical formal that determines which companies are included in the Dow, instead “a stock typically is added to The Dow only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.”

According to the Manager of the index the change from AT&T to Apple is not a direct reflection of the reputation or performance of either company. Instead, the change is based on the fact that Visa will be executing a stock split “that would reduce the weight of the information technology sector” (abcnews.go.com). Even though this change does not have to do with competition between the two companies, it is important to note that Apple has the dimensions necessary to be selected as a Dow company. It says something important about the stature of the company (as it should with a market cap of over $700 billion!) and the significance of the Information Technology sector to the US economy.

There are some drawbacks to the index when compared to other popular indexes such as the S&P 500. One difference Between the Dow & the S&P 500 is that the S&P includes 500 companies while the Dow only includes 30. Therefore the S&P 500 analyzes a larger cross-section of the economy. The other main difference between these two indices is the Dow is price-weighted while the S&P 500 is market cap-weighted. This means Dow stocks with higher prices (in absolute dollar values) will weigh higher than companies with smaller stock prices. This skews the index in a way the S&P 500 is immune to. The S&P 500 calculation is based on the market cap of each company therefore the market value of the company is what matters, not the stock price.

How the Dow is Calculated
The Dow is calculated by summing the prices of the 30 included stocks and dividing by the Dow Divisor (current value is .15571590501117). Now you might think dividing by 30 would work better as an average however the problem is a simple average does not account for activities such as stock splits or changes to the lineup of companies. The Dow Divisor cumulatively accounts for all historical changes to the Average in order for the statistic to be undistorted. The next update to the Divisor will take place when Apple is officially included in the index.

Some other companies in the Dow include Caterpillar (CAT), Home Depot (HD) and McDonald’s (MCD). Refer to money.CNN.com for a complete list.

Some History
The Dow Jones Industrial Average dates back to 1896 when it was first published. Back then the Average only consisted of 11 stocks and used a simple average as mentioned earlier. As time went on the number of companies increased until it reached 30 in 1928. This is also the year the Divisor came into use. The Dow is owned by Dow Jones & company which in turn is owned by News Corp (as of 2007). Other entities owned by Dow Jones & Company include The Wall Street Journal and Barron’s.

To this day the Dow Jones Industrial Average is one of the most heavily sited financial statistics around. It’s the first number we want to see when we hear the market has moved up or down in a significant way. When it comes to numbers or anything we see everyday, it good to take a look behind the curtain once in a while and make sure we understand what we’re looking at.

Please leave me you comments.