The Dow Jones Industrial Average, or DJIA for short, is America’s oldest stock index and one of the most popular bellwether indicators followed by market analysts and investors. Comprising just 30 American blue-chip stocks, the DJIA is price-weighted, meaning that companies with higher stock prices have more influence on the index’s value than companies with lower prices.
Because of this, stock splits—through which a company increases its number of outstanding shares while lowering its stock price accordingly—could theoretically send the index’s value reeling.
Most popular stock indexes are capitalization-weighted rather than price-weighted, meaning the influence of each included stock is determined by its total market value. While a stock split does lower a stock’s share price, it doesn’t affect the underlying company’s market cap, so cap-weighted indexes don’t need to change their calculation to account for splits like the DJIA does.
Here’s how the S&P Global and Wall Street Journal representatives who manage the DJIA handle stock splits to avoid artificial volatility in the index.
What are stock splits & how do they work?
Sometimes, companies conduct stock splits to make their shares more affordable.
For instance, a company whose stock trades at $500 might want to make its shares cheaper to attract smaller investors. To do this, they could conduct a 5-for-1 stock split, in which every existing $500 share would instantly become five $100 shares.
Stock splits don’t affect the market value of the underlying company (its market capitalization) — they simply break the company’s stock shares into a higher number of lower-priced units.
Related: Dow Jones vs. S&P 500: Which index actually represents the market?
Stock splits have become less common since the advent of fractional share trading (which allows retail investors to buy fractions of stocks in specific dollar amounts rather than purchasing whole shares), since they were historically used to attract investors who might not have enough cash to buy whole shares of expensive stocks.
Nevertheless, stock splits are still conducted fairly frequently because they signal strength to investors, as they typically indicate that a stock’s price has been rising over the long term.
How does the Dow handle stock splits?
As mentioned above, the Dow is a price-weighted index, so price changes in higher-priced stocks affect the index’s value more than price changes in lower-priced stocks.
Since stock splits can instantly cut a stock’s price in half, quarters, or even tenths, they could conceivably wreak havoc on the Dow if they weren’t accounted for in some way.
So, how are splits accounted for? By changing the Dow divisor, the ever-evolving denominator used to calculate the index’s value.
What is the Dow divisor?
The Dow divisor is the denominator in the equation used to calculate the Dow’s value. The formula looks like this:
DJIA = (Sum of each component company’s stock price) / (Dow divisor)
Originally, the Dow divisor was equal to the number of stocks in the DJIA, but it has been changed countless times over the 130 years the Dow has existed. Currently, it sits at 0.16242563904928, according to Barron’s Market Lab.
How is the Dow divisor adjusted when a stock split occurs?
When a stock in the DJIA conducts a stock split, the Dow divisor is immediately lowered to account for it in order to keep the value of the index stable. Here’s how the new divisor would be calculated after a stock split:
New Dow divisor = (Sum of each component company’s stock price after the stock split) / (DJIA value immediately before the stock split)
By lowering the Dow divisor by the exact amount necessary to keep the index’s price the same as it was immediately before the stock split, the index’s managers maintain continuity in the Dow’s value and prevent an artificial drop from occurring.
Related: Dow Jones’ revolving door: What happens to a stock after it’s dropped from the DJIA?
Example of a Dow divisor adjustment for a stock split
To conceptualize how the Dow divisor is adjusted for stock splits, picture a price-weighted index like the Dow, but with only three stocks. We can call it the Dew.
Stock A costs $100, Stock B costs $200, and Stock C costs $150.
The current Dew divisor is 3.
Dew = (Sum of prices of component stocks) / (Dew divisor)Dew = ($100 + $200 + $150) / 3Dew = $450 / 3Dew = 150
Now, let’s say Stock B conducts a 2-for-1 stock split, resulting in a new share price of $100 instead of $200. This means we need to change the Dew divisor to keep the index’s price stable:
New Dew divisor = (New, post-split sum of stock prices) / (Dew value immediately before the split)New Dew divisor = ($100 + $100 + $150) / 150New Dew divisor = $350 / 150New Dew divisor = 2.333
Now, we can recalculate the value of the Dew using Stock B’s new price and the new Dew divisor, and the result should be the same as it was before the split:
Dew = ($100 + $100 + $150) / 2.333Dew = $350 / 2.333Dew = 150
Success!