Les Jones

Economics > Dow Jones Snubs Google & SIDNK About the DJIA

(SIDNK = Something I Did Not Know.)

From The Globe and Mail via Search Engine Land:

The official explanation from Dow Jones & Co. is that the DJIA already has enough technology exposure with stocks such as Microsoft and Intel. Tech "seems to be at about the right weight in the Dow compared to the market as a whole, so we did not make any moves in that regard at this time," John Prestbo, editor of Dow Jones Indexes, told journalists on a conference call yesterday.

What he didn't say was that the Dow is a price-weighted measure, meaning higher-priced stocks wield more influence than lower-priced ones. Most indexes, by contrast, are weighted by market-cap, such that larger companies hold the most sway regardless of whether their stock trades for $25, $50 or $100. This is what makes the Dow such a strange animal.

But why does this matter? Because if Google, which trades for more than $500, were allowed to join the Dow, it would immediately overwhelm all the other constituents. Even small percentage changes in the stock would cause huge swings in the average, rendering the Dow useless as a benchmark.

I'm shocked that the Dow Jones is weighted by share price. How dumb. For large, long-established companies share price is largely arbitrary because it depends on the number of stock splits or reverse stock splits. Market capitalization - the number of outstanding shares multiplied by the share price - is a much more rational measure.

UPDATE: For people who aren't into stocks or stock lingo here's an explanation of why the Dow Jones method is silly. Imagine instead of companies we're talking about two cars - a $25,000 Honda and a $100,000 Mercedes.

Now let's divide the ownership of the cars into shares. We'll divide the $25,000 Honda into a hundred shares that cost $250 each. Well divide the $100,000 Mercedes into 1,000 shares that cost $100. (Why? Just because. Like I said above, this is arbitrary.) If you only look at the share price it looks like the Honda is worth more than the Mercedes. That's because I manipulated the share price by issuing fewer shares of the Honda and more shares of the Mercedes.

To see that the Mercedes is worth more than the Honda you have to look at the total price, which is the number of shares times the price of each share. That's what the market capitalization is - the number of shares times the price of each share. The Dow Jones Industrial Average doesn't use the market capitalization to determine the value of companies in its index. Therefore it can wind up telling you that a Honda is worth more than a Mercedes.