If you spend any amount of time as a regular here, you see I almost never talk about the Dow Jones Industrial Average. Part of that is because it is only 30 stocks (versus 500 in the S&P 500) but mostly it's due to the weightings in the index. Unlike most indexes, which are market cap weighted (bigger companies get a bigger slice of the index) the DJIA is price weighted. Meaning a $200 stock would have 10x more influence than a $20 stock. Obviously stock price in and of itself is meaningless. If you issue enough shares or do enough splits you could have a $18 stock in a $150B market cap company. Or vice versa, if you came to market with very few shares and never split you could have a $50B company with a stock price in the $400s. Bottom line, the DJIA methodology is 'dumb.'
To wit, currently IBM has a 10%ish weighting (the most in the index), as opposed to a 3.33% weighting if the Dow was equal weighted, solely due to it having the highest stock PRICE amongst the Dow 30. Meanwhile, GE, Alcoa (AA) and Bank of America (BAC) combined represent 3% of the Dow. Say what you want about Bank of America or Alcoa, but those 2 combined with the proverbial industrial/financial juggernaut (GE) in the country are only 3%? Silly.
BusinessWeek has a look at what would happen if Apple (AAPL) - with its >$400 stock price - was part of the DJIA. (please note this is article is a few months old, and in the meantime Apple has passed Exxon (XOM) in market cap - hat tip Markbeat)
- Since 1896, when the Wall Street Journal's first editor and co-founder, Charles Dow, compiled a portfolio of bellwether industrial stocks, the Dow Jones industrial average has sought to reflect the changing U.S. economy.
- The benchmark has sometimes been slow to keep up with the times. The Dow booted Woolworth for Wal-Mart (WMT) in 1997 and didn't add Microsoft (MSFT) and Intel (INTC) until 1999. Even so, the 30-member index remains the most widely recognized measure of the market.
- Today the Dow is notable for one giant omission: Apple (AAPL), the world's leading tech stock. With a market value of $307 billion as of June 14, the maker of iPhones and Macs is the second largest company in the U.S., behind ExxonMobil (XOM), a Dow component, and almost as large as Microsoft and Intel combined. (has since changed)
- "Apple should be in the Dow," says Paul Hickey, of Bespoke Investment Group in Harrison, N.Y. "Just as there used to be a General Motors (GM) vehicle in nearly every American driveway, there's now an Apple product in practically every American household."
- Apple's absence, says Hickey, has deprived the Dow of 1,000 points. He calculates that if Apple had been added to the Dow instead of Cisco (CSCO) in June 2009, when bankrupt GM was ousted, the blue chip index would have closed at 13,081 on June 14, 8.3 percent higher than its actual level of 12,076.
- So why hasn't Apple joined the club that includes JPMorgan Chase (JPM) , Kraft (KFT), Caterpillar (CAT), and other household names? The answer lies in the peculiar way the Dow index is calculated. Most benchmarks, including the Standard & Poor's 500-stock index, weight their components by market value, which is the share price times the number of shares outstanding. The Dow uses only one component of that equation: stock price. Thus IBM, at $164, holds the top weighting in the Dow, 10 percent, even though it is only third by market value.
- Meanwhile, because General Electric (GE), Alcoa (AA), and Bank of America trade in the teens, they represent a combined 3 percent of the Dow—less than a third of IBM's weight.
- With a share price of about $330, Apple would dominate the Dow, accounting for more than 17 percent of the index. (That was at $330, Apple is now north of $420! I assume its share would be closer to 20% than 17% now) A 1 percent change in Apple's stock price would translate to a 23-point change in the Dow.
- That kind of outsize impact, says Rubin, "would pretty much make the Dow irrelevant. I agree: Apple should be in there. But at this price, you can't just put it in." The keepers of the Dow acknowledge the problem. "Apple, at its current price level, would distort the Dow," says Prestbo.
- While there are trillions of dollars indexed to the S&P 500, only $37 billion are in funds that follow the Dow.