The Stock Market

Since there was some interest into the construction and meaning of the two major indices measuring the stock market, I thought I would write a little about them. The two indices are:

  1. The Dow Jones Industrial Average (DJIA) and;
  2. The Standard & Poor’s 500 (S&P 500)

As I had mentioned in class, the DJIA contains the 30 largest and most widely-held (in terms of market capitalization) companies traded in the United States. It is one of the oldest indices in the country. From the FAQ on the Dow Jones website, in answer to the question, “How are stocks picked for the DJIA?”

The editors of The Wall Street Journal select the components of the industrial average. They take a broad view of what industrial means, too; in essence, it is almost any company that isn’t in the transportation business or isn’t a utility (because there also are Dow Jones Averages for those kinds of stocks). In choosing a new company for the DJIA, they look among substantial industrial companies with a history of successful growth and wide interest among investors. [DJIA FAQ]

Amongst the companies listed on the DJIA are Disney, 3M, Microsoft and more. Dow Jones has a complete component list on its website [xls].

The S&P 500 index, on the other hand, contains 500 companies, which cover approximately 75% of the US Stock Market. They use a number of factors to select the stocks in the index, and among them are the following:

Index constituents exhibit the following characteristics:

  • Market Coverage – Approximately 75% of the U.S. equities market
  • Weighting – Market capitalization
  • Market Capitalization – Minimum of US$ 5 billion
  • Public Float – At least 50%
  • Reconstitution – As needed basis

[From Standard & Poor’s page on the S&P 500]

Some more details on the selection criteria are given on the S&P500 factsheet [pdf] and they include

  • Financial Viability – four consecutive quarters of positive earnings
  • Adequate Liquidity and Reasonable Price – the ratio of annual dollar value traded to market capitalization for the company should be 0.30 or greater (very low stock prices can affect a stock’s liquidity)
  • Sector Representation – companies’ industry classifications
  • Company Type – constituents must be operating companies

A key difference between the DJIA and the S&P500 is the way in which they are constructed.

The DJIA is a price-weighted index, which is basically the average of the stock price of the 30 companies. However, to maintain continuity in the index as companies change, the divisor for the index has been changed – which is why the number is much larger than each individual component’s stock price. More on the DJ website.

The S&P500 is a value-weighted index. Here, each company is weighted based on its market-value, which means larger companies will get higher weights added to them. This is so that, if a company has a larger market value (with more shares outstanding, and a higher stock price), then a change in that company’s stock price will affect the index more than a company with a smaller market value.

In the DJIA, a dollar change in any company’s stock price will cause a shift of similar value to the index, regardless of how small or large the company is (in terms of shares outstanding, and stock price).

Also, for the S&P500, from the point above – “Public Float – At least 50%” – each company must have at least 50% of its shares available for public trade. For example, Google only considers a portion (more than 50%, though) of its shares as tradeable, known as Class A shares. The S&P500 considered only these Class A shares to calculate its market value when it added Google to the S&P 500. Because of this additional rule (implemented over a period of months in 2005), the S&P 500 is now referred to as being “float-weighted” rather than value-weighted.

Self-challenging exercise: Can you figure out which was the latest addition (deletion) to the S&P500, and when it happened? How about for the DJIA? Use the links on this posting to start you off.

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