It's been a crazy year for the Dow Jones Industrials (DJINDICES: ^DJI). The COVID-19 pandemic brought the average its first severe bear market in over a decade, and just as abruptly, the average bounced back. It's now getting close to reaching new record levels.
As if that weren't enough, S&P Dow Jones Indices decided to make major changes to the Industrial Average. Out are energy giant ExxonMobil (NYSE: XOM), stalwart pharmaceutical company Pfizer (NYSE: PFE), and defense contractor Raytheon Technologies (NYSE: RTX). In are software provider salesforce.com (NYSE: CRM), manufacturing company Honeywell (NYSE: HON), and biotech favorite Amgen (NASDAQ: AMGN).
The moves will have a substantial impact on the Dow overall. They'll reduce its exposure to energy and traditional pharmaceuticals in favor of tech and biotech, and will substitute the much-changed Raytheon with a former Dow component in Honeywell. Yet they'll also affect the other 27 stocks and their influence in the Dow. Here's how.
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Big changes to a price-weighted index
The Dow's methodology for calculating its value is highly unusual. Rather than weighting components by market capitalization, the Dow simply takes the stock prices of its 30 constituent stocks and adds them together. It then applies a factor known as the Dow divisor to ensure historical continuity. That simple method is all it takes to come up with the current value of the Dow.
That means that higher-priced stocks have more influence in the Dow, while lower-priced stocks have less. ExxonMobil, Pfizer, and Raytheon were among the lowest-priced stocks in the Dow. That makes their exit less impactful than it would have been if S&P Dow Jones Indices had chosen higher-priced representatives of their respective industries. Chevron, for example, has more than double the weighting that Exxon has.
All told, the roughly $140 in combined share price from the three exiting Dow stocks works out to just 3.5% of the total index. However, the three incoming stocks all trade at prices between $160 and $250 per share, adding up to nearly $630. The boost will take the total of all 30 stocks from around $4,200 to $4,700, and the three new stocks will have more than 13% of the Dow's total weight.
The other 27 stocks, conversely, will go from having 96.5% of the influence over the Dow to just over 86.5%. Much of that 10-percentage-point decline will go to Apple (NASDAQ: AAPL), because its per-share price is set to drop by roughly $375 after its 4-for-1 split is finalized. However, the remaining Dow stocks will also lose a portion of their weight in calculating the Dow.
A new Dow divisor
The substitution of higher-priced stocks will also lead to a new Dow divisor. The current value of approximately 0.147 means that for every $1 a stock in the Dow gains or loses, it has a 6.78-point influence on the Dow itself.
Higher-priced substitutes will tend to increase the divisor, while Apple's stock split will have a downward influence. The net effect won't be certain until the end of trading on Aug. 28. However, it's likely that the three new stocks will more than offset Apple's impact, leading to a slightly higher divisor and a slightly smaller point change per dollar of movement.
Get ready for a new Dow
The blue chip stocks in the Dow Jones Industrials have always been among the cream of the crop of the American business world. Changes inevitably happen not only to the companies directly affected but to the rest of the Dow as well. When the new Dow 30 opens for trading on Aug. 31, be ready to see what a new era for the average brings.
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Dan Caplinger owns shares of Apple. The Motley Fool owns shares of and recommends Apple and Salesforce.com. The Motley Fool recommends Amgen. The Motley Fool has a disclosure policy.
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