Understanding the Dow Jones Industrial Average (DJIA)
What is the Dow?
The Dow Jones Industrial Average (DJIA) is perhaps the most widely followed stock market index in the world. Yet, very few people actually know that the number represents just 30 companies.
The Birth of the Dow Jones Industrial Average
The Dow Jones Industrial Average was introduced on May 26, 1896. The Dow was created by a man named Charles H. Dow, one of the founders of Dow Jones & Company, which was formed in 1882.
Dow's first index was created in 1884, and consisted of 11 transportation-related stocks. He adjusted the original index (on Wall Street, this process is known as “reconstituting”) and renamed it the Dow Jones Rail Average (in the 1970’s, the name was updated to the Dow Jones Transportation Average to cover the introduction of air freight and other forms of transportation).
Dow soon realized that industrial companies were quickly becoming more important than railroads. He then created a new index of stocks consisting of twelve companies and called it the Dow Jones Industrial Average or DJIA for short. The index originally consisted of industrial-sector companies, including those focused on cotton, sugar, tobacco, and gas.
To calculate the reported index figures, Dow added up the stock price of selected companies, divided by the number of companies in the index at the time.
The very first published Dow Jones Industrial Average figure was 40.94. In simple terms, it means 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 Dow Jones Industrial Average consisted almost entirely of commodity-based firms and were as follows:
- American Cotton Oil Company
- American Sugar Company
- American Tobacco Company
- Chicago Gas Company
- Distilling & Cattle Feeding Company
- General Electric
- 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 respected firms. Most were eventually replaced in the Dow Jones Industrial Average.
Changes Over Time
In 1916, the Dow Jones Industrial Average was updated to include 20 stocks. By 1928, the DJIA was expanded to 30 stocks, which continues to be the rule today.
A committee made up of S&P Dow Jones Indices representatives and The Wall Street Journal editors decide which companies are included in the Dow Jones Industrial Average.
There are no rules for Dow inclusion, just a set of broad guidelines that require large, respected, substantial enterprises that represent a significant 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 August 31, 2020. Amgen, Honeywell, and Salesforce were added while ExxonMobil, Pfizer, and Raytheon were deleted. The 30 Dow component companies are:
- American Express
- Cisco Systems
- Goldman Sachs Group
- Home Depot
- Honeywell International
- Intel Corporation
- Johnson & Johnson
- JPMorgan Chase
- Procter & Gamble
- The Travelers Companies
- UnitedHealth Group Inc
- Walt Disney
Criticisms of the Dow Jones Industrial Average
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 latter company had a market capitalization that was 10 times as large.
That’s why a company such as Berkshire Hathaway (BRK/A), which regularly trades at over $250,000 per share, couldn’t be added to the Dow without some sort of modification in the formula because it would instantly represent the entire index.
This flaw quickly became apparent when companies announced stock splits and other transactions that modified their nominal share price. A growing company, to make their shares affordable, may double their stock outstanding by splitting 2-1.
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 meaningless cosmetic change would result in the DJIA falling even if the stocks increased in value.
To compensate, the divisor of the DJIA is frequently modified for corporate events and transactions, such as special dividends and stock splits.
Structurally, critics argue against the practice of disregarding the overall size of a firm, focusing instead on a meaningless nominal value that can be modified through share repurchases or issuance. Some professional money managers instead use the S&P 500, which adjusts for overall market capitalization.
The Bottom Line
The Dow Jones has changed quite a bit over the past 100 years, and will continue to change and evolve as the economy shifts. While it isn't the broadest measure of economic health, understanding the Dow's history and makeup can help you decipher a common term in financial circles.