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The Dow divisor is used to calculate the Dow Jones Industrial Average (DJIA), which is done by summing the prices of all its constituent stocks and dividing that sum by the divisor. The Dow Jones Industrial Average (DJIA) is considered a symbolic indicator of the stock market. It is reported daily in financial news and is a favorite topic among commentators and market experts. The Dow divisor is used to calculate the average by summing the prices of all its constituent stocks and dividing that sum by the divisor. It is also a critical part of the criticisms directed at the Dow as a measure of stock market performance.

Definition and Example of the Dow Divisor

The Dow Jones Industrial Average was introduced in May 1896. The original average was the daily average of stock prices for 12 industrial companies selected by the founder of The Wall Street Journal, Charles Dow, to represent sectors of the American economy. The original average started at 40.94. Since 1928, the average has consisted of 30 companies. The last of the original 12 Dow companies, General Electric, was removed in 2018.

Most major financial market indices rely on market capitalization. These indices are calculated by weighting the stock price of each company in the index according to size or market value. If Company A has a market value of $20 billion and Company B has a market value of $40 billion, for example, the stock of Company B will count twice as much as the stock of Company A in most indices.

However, the Dow index is presented based on prices. Companies with higher stock prices have a greater impact on the average compared to companies with lower stock prices. Changes in the stock of Apple, priced at $177.34, affect the average more than changes in Coca-Cola, priced at $57.57. When a stock split occurs, such as Apple’s 4-for-1 split in August 2020, it can have a significant impact on the Dow average. As a result of this split, Apple’s stock price dropped to around $125 from nearly $500 in one day. Thus, the Dow divisor is used to maintain stability in the average and adjust for splits, dividends, and losses in stocks, as well as additions and deletions of companies, along with 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 index was introduced, the stock price for each of the 12 companies was summed and divided by 12, which was the original divisor. Stock splits were handled by “weighting” a company’s stock price according to the split. If Company A had a stock price of $10 and was split 2-for-1 to $5 per share, Company A’s stock price would then count as two. Of course, it became difficult to maintain this method as the Dow grew to 30 companies.

In 1928, a new method for handling splits was introduced that adjusted the divisor instead of weighting the stock price. The divisor is adjusted such that the average after the split equals the average before the split.

Here is an example using three companies: A, B, and C:

• The price of Company A before the split is $10.
• The price of Company B before the split is $20.
• The price of Company C before the split is $30.

Thus, the average before the split is $20: (A + B + C) / 3 = $20

Then

Company C executes a stock split of 2 for 1.

• Company A’s price after the split remains $10.
• Company B’s price after the split remains $20.
• However, Company C’s stock price after the split on a 2 for 1 basis becomes $15.

Thus, the divisor after the split changes to 2.25 instead of 3: (A + B + C) / 20 = 2.25, while the average remains $20 after the split: (10 + 20 + 15) / 2.25.

Criticisms of the Dow Divisor

The method for calculating the Dow divisor leads to an estimation of stock price performance compared to actual performance and may not represent the U.S. market well. Let’s take a look at what happens in our example if Company C’s stock price rises to $20 after the split. The average = 10 + 20 + 20 / 2.25 = $22.22. If we used the old method to weight the price before the split, here’s the result: average = 10 + 20 + (20 × 2) / 3 = $23.33.

Inconsistent Dividend Distributions

Dividends are similar to stock splits. Instead of a cash distribution, additional shares are granted to shareholders. For example, a shareholder owning 100 shares at a 5% rate will receive a proportional distribution of 5% of additional shares.

Over the years, the Dow divisor has not been consistently adjusted for dividends.

What This Means for Individual Investors

At the end of each trading day, analysts often discuss the 30 companies in the Dow Jones Industrial Average. Investors can calculate the impact of a change in a company’s stock price by dividing the increase or decrease by the divisor. For example, if Apple’s stock price rises by 10 points and the divisor is 0.15172752595384, then Apple’s stock accounts for approximately 66 points of the change in the Dow. The divisor is published daily in the Wall Street Journal and Barron’s.

Takeaways

The Dow divisor is used to make adjustments to the Dow Jones Industrial Average for stock splits and other changes in the stocks of the Dow component companies. The Dow divisor is maintained by the S&P Dow Jones Indices. Criticisms of the divisor include its estimation of stock price performance and inconsistent dividend distributions.

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Sources:

• Library of Congress. “Dow Jones Industrial Average First Published.” Accessed Dec. 13, 2021.
• The University of Richmond. “Can General Electric Ever Return to the Dow?” Accessed Dec. 13, 2021.
• Apple. “Investor Relations FAQ.” Accessed Dec. 13, 2021.
• S&P Dow Jones Indices. “U.S. Equity Dow Jones Averages.” Accessed Dec. 13, 2021.
• Jacky Lin, Genevieve C. Selden, John B. Shoven, and Clemens Sialm. “Replicating the Dow Jones Industrial Average,” Page 2, National Bureau of Economic Research Working Paper Series. Accessed Dec. 13, 2021.
• Barron’s. “Market Lab.” Accessed Dec. 13, 2021.

Source: https://www.thebalancemoney.com/what-is-the-dow-divisor-5213031