For only the 57th time in the more than 124-year history of the iconic Dow Jones Industrial Average (^DJI -1.71%), changes are about to be made.
On Monday, Aug. 24, S&P Dow Jones Indices, which monitors the 30 companies that make up the Dow Jones, announced that three current Dow components will get the boot before the market opens on Aug. 31, with three new companies taking their place.
These well-known companies are being kicked out of the Dow Jones
Headed out of the Dow are:
The removal of Raytheon isn't a huge surprise after United Technologies merged with Raytheon earlier this year. The same could be said for Pfizer's dismissal after more than 16 years in the Dow. Rival Merck is similar, and having two pharmaceutical companies in the Dow always seemed a bit repetitive.
The real surprise here is that oil and gas giant ExxonMobil is being shown the door. ExxonMobil has been a Dow component since 1928, back when it was known as the Standard Oil Co. of New Jersey. Next to General Electric's roughly 110-year consecutive run in the Dow (which ended when General Electric was kicked out of the Dow in 2018), ExxonMobil's 91-year streak is the Dow's second-longest. And it's about to come to an unceremonious end.
There'll be some new stocks in the Dow come Aug. 31
Replacing ExxonMobil, Pfizer, and Raytheon in the Dow Jones Industrial Average are:
Salesforce, the cloud-based customer relationship management solutions provider, will bring a cutting-edge look to the Dow while also beefing up its technology sector exposure. Meanwhile, biotechnology blue chip Amgen will presumably offer more growth potential than Pfizer.
Finally, diversified technologies company Honeywell returns to the Dow after previously getting replaced by Altria Group in September 2008. Prior to Honeywell's 2008 removal, it had been a fixture in the Dow since December 1925, when it was then known as Allied Chemical and Dye Corporation.
The real reason Exxon, Pfizer, and Raytheon are getting the heave-ho
On the surface, there appear to be a number of reasons S&P Dow Jones Indices made these changes.
As noted, Pfizer and Merck were somewhat redundant Big Pharma entries, so one was bound to get the boot eventually. The addition of Amgen provides a mature company with a potentially more robust long-term growth rate relative to a pharmaceutical stalwart like Pfizer.
An argument could also be made that the addition of Salesforce adds cloud-computing exposure to the Dow beyond the exposure offered by IBM.
But these aren't the real reasons the S&P Dow Jones Indices is removing ExxonMobil, Pfizer, and Raytheon. You see, the Dow Jones Industrial Average is a price-weighted index. This means that share price, not market cap, matters in calculating the indexes' point value. Thus, a $200 per share stock has twice the influence of a $100 stock, and four times the influence of a $50 stock, regardless of market cap.
ExxonMobil, Pfizer, and Raytheon have respective share prices of $42.22, $38.84, and $61.88, as of the closing bell on Aug. 24. Using the current Dow divisor of approximately 0.147, every $1 in share price is "worth" approximately 6.78 Dow points. Adding up the share prices of ExxonMobil, Pfizer, and Raytheon shows that they were only responsible for 969.21 Dow points on a combined basis.
Comparatively, the incoming Salesforce, Amgen, and Honeywell have respective share prices of $208.46, $235.57, and $159.37. Admittedly, these incoming stocks, along with the pending 4-for-1 split of Apple, will cause the Dow divisor to be adjusted in the coming days. But the fact is that these changes are about share price and a company's relative influence on the Dow, and probably little else.
The Dow Jones Industrial Average has numerous flaws
The Dow Jones is undoubtedly rich with history, but it's an almost unusable index by today's standards given its many flaws.
As stated, it's a share-price-weighted index that doesn't pay any heed to market cap. This means investment bank Goldman Sachs and its $71 billion market cap (but $207.34 share price) has nearly five times the influence of networking giant Cisco Systems, which has a $42.18 share price, but over twice the market cap ($178 billion).
What's more, the Dow doesn't do a great job of representing the varied sectors of the U.S. economy. Unlike the broad-based S&P 500, you'll find no utilities or real estate representation in the Dow Jones. There soon will be just one energy stock, Chevron, to go along with only one materials company, Dow.
Lastly, because the Dow's divisor is dependent on share price, some of the largest companies in the world with very large share prices could never join the index. For example, Amazon and Alphabet, the parent company behind Google search and YouTube, are the respective third- and fourth-largest companies in the U.S. by market cap. But with shares prices that are north of $3,300 and approaching $1,600, Amazon and Alphabet have no chance of joining the Dow without enacting a stock split.
The Dow Jones Industrial Average is a great index to reminisce about, but it shouldn't be taken seriously by investors as an accurate barometer of the health of the stock market or U.S. economy.