You're probably very familiar with the term "Dow Jones Industrial Average." But if you're like many people, you've rarely given much thought to how the average is calculated. So get a load of this.
The Dow is essentially the average price of its 30 component stocks, which include United Technologies, Verizon, AT&T, General Electric, Caterpillar, and Coca-Cola. This may seem strange, though, with the Dow recently around 11,000 and none of the 30 stocks trading anywhere near $11,000 per share.
On average, though, the shares really would trade in the neighborhood of $11,000 -- if they had never been split, issued dividends, or undergone major changes such as spinoffs or mergers during the time they were listed in the index.
For example, consider a share of Microsoft. If you bought one share of the company when it came public in 1986, it would have been worth less than $100 at the time. But as of the time of this writing, the stock has split nine times, and that single share has become 288 shares, each worth about $25. Total it up, and that single initial share has grown to be worth roughly $7,000.
Today, though, most stocks don't trade at such lofty levels -- thanks to events such as stock splits. To get from current stock price levels to the larger index number, a number called the "divisor" is used. Here's how it works. If General Electric falls 4 points, you just divide four by the divisor (which is adjusted frequently and was 0.12493117 last time we checked). This shows that this drop will decrease the DJIA by 32 points (4 divided by 0.12493117 equals 32). The overall average is calculated by adding up the current stock prices of the 30 stocks and then dividing by the divisor.
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Coca-Cola and Microsoft are Motley Fool Inside Value picks.AT&T is a former Stock Advisor pick.
