If you follow the markets, you probably know that the Dow Jones Industrial Average tracks the value of 30 stocks -- but you may wonder how those 30 stock prices turn into the number that shows up on every evening newscast. That's due to the divisor: a mathematical factor that's used to calculate the Dow's level.
Calculating the Dow
The Dow Jones Industrial Average lives up to its name, and is calculated like an average. A true average would be the total of the share prices of the 30 Dow stocks divided by 30. However, instead of dividing by the number of stocks, the Dow is calculated by dividing the total of the share values by the current divisor published by the Dow Jones Company. In March 2013, the divisor stood at 0.130216081.
Why a Divisor?
The divisor used to calculate the Dow changes to maintain the relative value of the index when a corporate action results in a stock price change that does not change a company's value. The best example is a stock split, in which more shares are issued to lower the share price. An investor who owns a stock that splits has the same amount after the split as before, even though the share price is lower. The Dow Jones divisor also changes when a stock is dropped from the list and another one added. It is highly unlikely that the new stock will have the same share price as the old, so the divisor changes to allow the Dow Jones value to maintain continuity.
Divisor Change Example
Let's say you've started your own stock index, tracking two stocks each at $20 per share. Your initial index value is 20 -- 20 plus 20 divided by 2. Then one stock declares a two-for-one stock split, and the share price adjusts to $10. Now the mathematical average of your stocks is 15 -- 20 plus 10 divided by 2 -- yet the real values have not changed. However, if you use a divisor of 1.5, your stock index value goes back to 20. As a result of the stock split, the divisor on your two-stock index changed from 2 to 1.5 to keep the index value at 20. As the share prices of your two stocks change, the divisor of 1.5 will show the relative value of those changes in your index value.
Many Years, Many Changes
If you added up the 30 share prices of the Dow Jones stocks -- with the DJIA at 14,000 -- you would get a total of about 1,820 and a mathematical average of 60. The current divisor value means that the Dow Jones has increased by a factor 230 times greater than what's indicated by the current share prices of the 30 Dow component stocks. The divisor has kept the value of the Dow Jones relevant to the actual value changes of the stocks tracked by the index. In sum, using a divisor ensures that the changes in the Dow Jones Industrial Average keeps up with what investors would have earned in the market through many years of component changes and stock splits.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.