Calculating the Dow Has Grown More Complex

When Charles Dow created his first stock index with 11 stocks in 1884, he could easily calculate it every day. He simply totaled the sum of the share prices and divided by the number of stocks in the index.

Computing the Dow average is more complicated today, but the basic formula holds.

The Dow is still figured by tallying the prices of the stocks that make up the index. But instead of dividing their total by 30--the number of stocks now in the Dow--a special divisor must be used.

The divisor maintains the historical continuity of the Dow by adjusting for the effects of stock splits and for the substitution of stocks in the index. It’s necessary because the Dow is “price-weighted” rather than “market-capitalization-weighted.”

Many other market barometers, such as the Standard & Poor’s 500 index, are calculated based on the market value of their companies. Market value is derived by multiplying a company’s number of outstanding shares by its stock price.

Thus, large companies with many shares have a greater influence on the index than do smaller ones with fewer shares (and, often, lower share prices).

The value of the Dow, by contrast, is calculated solely on the prices of its individual stocks. Thus, a $100 stock in the Dow has twice the impact as a $50 stock in terms of the index’s movements.

Here’s why a special divisor is needed, and why it must be adjustable: Imagine that a $100 stock undergoes a 2-for-1 split. If the divisor is not adjusted, the new $50 stock price would cause the Dow to drop even though everything else had remained constant. (The same principle holds if a Dow company with a $50 stock price replaces one with a $100 stock price.)

Each time a Dow stock splits, the divisor is adjusted downward to reflect the lower stock price.

The Dow divisor today is 0.22522230.