The Dow divisor, in simple terms, is a number used to help calculate the Dow Jones Industrial Average (DJIA). The divisor began as the equivalent of the total number of the stocks in the average, which was 30. Over time, however, the divisor was changed due to the need for calculating stock splits and changes to companies included within the average.
The Dow Jones Industrial Average (DJIA)
The Dow Jones Industrial Average (DJIA), often referred to merely as the Dow, is a stock market index designed to give an average or basic idea of how 30 of the largest publicly traded companies traded in the market during a typical trading session.
It is important to understand that the DJIA average is not a weighted mean, nor is it representative of the market capitalization of each individual company included within the index. It is simply used to indicate the average stock price, per share, for each company. The Dow Divisor is an important component of the DJIA.
History of the Dow and the Dow Divisor
When the DJIA was first created, 30 of the largest publicly-traded US companies were compiled into an index. The goal, ultimately, was to give investors the average price, per share, of stock. To accomplish the objective, the 30 stocks’ prices were added together and divided by 30, thus indicating the average price, per share, of stock.
Over time, the need to revise the calculation became obvious, as other mitigating factors needed to be considered when determining price averages. Fluctuations in the market, the rise, and fall of stock prices, and other major factors such as the market share of the early 1900s and the total stock market crash of 1929 – leading to the Great Depression – exerted an effect on average share prices and ultimately needed to be accounted for.
The Dow divisor fell below 1 in 1986 and, as of 2018, sits right around 0.147. The shrinking of the divisor is necessary to help balance the average when things like dividends and stock splits are folded into the equation.
The formula for the Dow Divisor
Because the Dow divisor needed to change over time to make space for changes within the market, the formula or equation used to calculate the average changed as well. Initially, the formula for calculating the DJIA looked like this (with p being the prices of component-company stocks and d being the Dow Divisor:
In order to make room for market changes, as well as to maintain some type of historical continuity and allow for the ability to draw comparisons between past and present Dow averages, the Wall Street Journal – which is responsible for the DJIA – adjusts the Dow divisor, modifying the index.
Stocks splits, changes to or payment of dividends, and other changes within the market make it necessary for the Dow divisor – and ultimately the formula – to change. In order to maintain some type of continuity and allow for these changes, the updated Dow divisor is used, and the formula currently looks more like this:
As of the end of June 2018, the Dow divisor is 0.14748071991788. It means that for every $1 of change in price for any given stock within the index, the average – using the current Dow divisor – is equal to a 6.781-point movement in the market.
Keeping the Dow divisor updated keeps the Dow closest to fair value and makes it easier for traders and investors to review accurate averages and make the best moves, both for themselves and for the clients they represent.
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