The Dow Jones Industrial Average is probably the best known index for tracking the United States stock market. The purpose of the index is to represent the United States economy by tracking the 30 largest companies based in the US. When it was first created it followed companies that were considered to be the backbone of the US economy. This sounds logical at first glance because the success of the largest companies in the US somewhat represent the success of the US economy. However, there are a few things about the Dow Jones that make it less than a perfect representation, and dare we say it, an irrelevant index.
The first issue is that the companies in the Dow may be based in the United States, but many of them make a good portion of their profits overseas. This wouldn’t be an issue if the Dow Jones was meant to represent the worldwide economy, but it isn’t. The Dow intends to represent the United States economy, and companies like Coca-Cola and McDonalds are misleading as much of their profits come from outside the United States.
The next issue, and the biggest, is how Dow index is calculated. The weight each company has on the index is based on stock price rather than market cap. To clarify, the stock price is the value of a single share of stock on the market. The market cap, or market value, is the stock price times the number of shares outstanding. This is an issue. Let’s say Company A has 100,000 outstanding shares at $100 each. The market value of Company A is then $10 million. Now, Company B has 1 million shares at $50 each. Because of that stock price, Company A has twice as much weight in the Dow than Company B, but Company B is valued at $50 million while Company A is only valued at $10 million. Due to this price weighted index, the smaller company’s movement in stock price is going to affect the index more than the larger companies!
The Dow Jones Industrial Average is a valuable index when looking at the market, but only when compared to a base value. As of 6/1/2018 Boeing has the highest stock price on the DJIA priced at $353.04 with 583 million shares outstanding. This represents a market value of 205.7 billion dollars. If the stock price increases by 10% the Dow will increase by about 1%. Cisco, another Dow component, has a market value of $205.8 billion, but a stock price of only $42.72, due to its 4.8 billion outstanding shares. If this stock price were to increase by 10%, the Dow would only increase 12 basis points. These companies are almost the exact same size, but since the Dow is a price-weighted index, the larger priced stock has a significantly greater effect.
Now what would happen if we took the company with the greatest market value and increased its stock price by 10%? Apple has the greatest market value at $948.6 billion but the stock price is only at $186.96. A 10% move would only increase the Dow by 53 basis points. For a company that is more than twice as large to have half the effect on the index is proof enough that the Dow is a flawed index.