Coke To Split: Should The Dow Change Its Components?

Jul.11.12 | About: SPDR Dow (DIA)

On Tuesday morning, Coca-Cola (NYSE:KO) announced a 2 for 1 stock split, the 11th split in company history and the first in 16 years. The number of authorized shares will double from 5.6 billion to 11.2 billion. As per the press release:

The record date for the stock split is expected to be July 27, 2012, with new shares expected to be distributed on or about Aug. 10, 2012. Each shareowner of record on the close of business on the record date will receive one additional share of common stock for each share held.

Coca-Cola has been a public company since 1919 and the first split was enacted in 1927. According to the company, if all dividends were reinvested annually, one share of the company's stock purchased for $40 in 1919 would be worth roughly $10.3 million today. It has been a great investment over time.

The stock split is nice, but the more interesting decision won't be made by the Coca-Cola company. As many investors now, Coca-Cola is one of the components of the Dow Jones Industrial Average (NYSEARCA:DIA). As per the history, the Dow Jones Industrial Average started trading in 1896. The complication here is that the Dow is a price weighted index, meaning that the Dow's value is calculated based on the share prices of its components, not their market caps like most other indexes. To calculate the Dow's value, the current prices of the 30 components are added, then divided by the Dow divisor.

The divisor is constantly changed when you get things like stock splits, so the Dow is going to need an update to the divisor when Coca-Cola splits. If the divisor was not updated, the index would lose value because Coca-Cola's share price has dropped. Here's an example of the divisor in theory, taken from the above linked history article.

To demonstrate how this use of the divisor works, we will create a mock index, the Investopedia Mock Average (IMA). The IMA is composed of 10 stocks, which total $1,000 when their stock prices are added together. The IMA quoted in the media is therefore 100 ($1,000/10). Note that the divisor in our example is 10.

Now, let's say that one of the stocks in the IMA average trades at $100 but undergoes a 2-for-1 split, reducing its stock price to $50. If our divisor remains unchanged, the calculation for the average would give us 95 ($950/10). This would not be accurate because the stock split merely changed the price, not the value of the company. To compensate for the effects of the split, we have to adjust the divisor downward to 9.5. This way, the index remains at 100 ($950/9.5) and more accurately reflects the value of the stock in the average.

So what am I getting to? Well, for a few years now, there has been a crowd arguing that the Dow should change its components, as certain components have a much higher weighting due to their much higher prices. For example, as of June 29th (pdf), IBM (NYSE:IBM), the most expensive stock in the index, had a weight of 11.49%. The next highest was Chevron (NYSE:CVX) at 6.2%, and so on. Exxon Mobil, which has the largest market cap of the 30 stocks, has just a 5% weighting.

As of that June 29th update, the top 10 Dow components (in terms of highest prices), had a 55.47% weighting in the index. So 1/3 of the index controls more than half of the movement. Wal-Mart (NYSE:WMT) is the 10th largest weighting at 4.1% and has a stock price around $72. Now imagine what the weighting of Bank of America (NYSE:BAC) is with its price at just $7.48. Alcoa (NYSE:AA) is in a similar place trading at just $8.40.

So maybe while they are changing the divisor again, it is time to change some of the components. The Dow Jones Industrial Average's stated objective is "To represent large and well-known U.S. companies. Covers all industries with the exception of Transportation and Utilities." So who do you take out, and who gets put in?

Bank of America and Alcoa have been named by many to be replaced because of their low prices. But I don't think you can take out Bank of America because it really represents the Dow, as a well-known U.S. company. Perhaps Bank of America should reverse split its stock and then have the Dow divisor change, which could boost its weighting.

The second theory I have heard is to replace Hewlett-Packard (NYSE:HPQ) with Apple (NASDAQ:AAPL). Hewlett-Packard has been struggling as a computer company in recent years and Apple is the biggest U.S. company by market cap. Apple certainly fits in the "well-known" category. The problem at this time is that with Apple trading at more than $600, you would almost have to force Apple to split its stock, otherwise the weighting would be just too high. I'm not sure that Apple wants to split right now, as the image of a high-priced, or premium stock, goes along with its premium products.

At this point, I don't see a logical change to the Dow, but I think that the Coca-Cola split does provide a good opportunity to do it. Why keep changing the divisor when you can do this all at once? I'm curious to hear your thoughts, and also to hear what you think should be replaced in the Dow and what should be put in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.