The Dow Jones Industrial Average (DJIA) added three and dropped three stocks yesterday. The additions were Amgen, Honeywell and Salesforce replacing Exxon Mobil, Pfizer and Raytheon. The changes were necessitated by Apple’s 4 for 1 split. The total components remain at 30 stocks.
Changes in the DJIA do not occur too often, so they are news of some sort. In this case, the Apple split reduced the percentage of the tech sector in the index. Here is why.
The S&P 500 and NASDAQ and many other indexes are weighted based on market value, i.e. market capitalization, of its components and the index rises or falls as those values change. The DJIA changes as the prices of each of its components change. An example is when the Apple share price increases by 1 percent, and if Apple has a market cap of $2 billion, then the S&P of NASDAQ index for that day will increase by $20 million (1 percent of $2,000,000,000 is $20,000,000). Big numbers. When Apple was $500 per share, a 1 percent increase was $5 per share. The DJIA would divide that $5 by a “divisor” which is about .15000 and that $5 would increase the index by about 33 points.
A divisor is a number that takes into account all stock dividends, splits and spin-offs so that continuity and consistency with earlier index values is maintained. I could provide illustrations how the divisor works, but for now it is not important – it is like understanding how a car runs or a hot dog is made. All that is necessary to know is that one-point change in a component’s stock price is increased by a factor of about 7 to cause the actual change in the DJIA index. With the Apple split, there are now four shares where there used to be one and a one percent change of a $125 stock price is $1.25. That $1.25 translated into DJIA points becomes an 8 point index change. Pre split it would have been a 33 point change. Therefore the “importance” of Apple in the index has been reduced. This also means that the DJIA index would not measure the “stock market” changes accurately (or rather as consistently as it has been doing it). Thus the change by adding Salesforce which is a software company classified in the technology sector. Since it was making that change the DJIA board decided Amgen better reflected the health care industry as a whole than Pfizer and that Honeywell was a better industrial sector component than Raytheon. In the shuffle, energy was downgraded with the removal of Exxon Mobil’s feeling that Chevron’s inclusion was adequate enough.
Removing these companies does not mean that they were not good companies, just that they were no longer suitable for the index the way the index is constituted. However, it likely would have an effect on the trading in those companies. Funds that mimic the DJIA index would be selling the three companies that were removed and purchasing the three that were added. This would probably cause excess trading in those six companies until portfolios are normalized. There should be no change in Apple ownership since it is still on that index, unless investors try to maintain a proportion and then they would be selling 75 percent of their Apple shares. None of this has an effect on the other indexes since the market cap of Apple has not changed.
There is an important “but!” The DJIA had a big run up this year because Apple more than doubled and if Apple now drops, it would have a much less significance in the index. So on some basis there will be an inconsistency. Also, Apple is paying a dividend, but as a percentage of the price of the stock it represented a yield of less than .7 percent so the change would only slightly affect the yield on the DJIA.
An added comment on the effect of price changes on the DJIA. Each dollar price change of Walgreens which trades at $39 per share would count the same as a change in United Health which is about $314 per share; but a 1 percent change in each company is $.39 vs. $3.14 and with the divisor adjustment there would be a 2.60 DJIA index change caused by Walgreens while a $21 index change would be caused by United Health. Therefore United Health has a greater effect on the index.
The actual divisor has changed to about .152000 up from .147000 with this being the first major change since April 2019.
I hope you found this helpful and interesting.
If you have any business or financial issues you want to discuss please do not hesitate to contact me at [email protected].
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