A Brief Summary
In the U.S. there are three major indicators, or indexes, of market movements. These three are the Nasdaq Composite, Dow Jones Industrial Average  (DJIA or " the Dow" ) and the Standard & Poor's 500. As a collective, these market indexes are referred to as the Security Market Indicator Series (SMIS). They provide a basic signal of how specific markets perform during the day. Of these three, the DJIA is the most widely publicized and discussed. Fortunately for us, it is also the easiest to calculate and explain.

The media always talk about the Dow being up or down a certain number of points, but what do these points represent? In this article we'll talk about how a change in the Dow corresponds to a tangible dollar value

Despite popular belief, the first averages were not published in the Wall Street Journal but in its precursor called the Customer's Afternoon Letter. The first averages didn't even include any industrial stocks. The focus was on the growth stocks of the time, mainly transportation companies. This means that the first Dow Jones Index included nine railroad stocks, a steamship line and a communications company. This average eventually evolved into the Transportation Average. It wasn't until May 26th, 1896, that Dow split transportation and industrials into two different averages, creating what we know now as the Dow Jones Industrial Average.

Charles Dow had the vision to create a benchmark that would project general market conditions and therefore help investors bewildered by fractional dollar changes.  A revolutionary idea at the time, and  its implementation was simple. The averages were, well, plain old averages. To calculate the first average, Dow added up the stock prices and divided by eleven, the number of stocks included in the index.

Today, the DJIA is a benchmark that tracks American stocks that are considered to be the leaders of the economy and are on the Nasdaq and NYSE. The DJIA covers 30 large-cap companies, which are subjectively picked by the editors of the Wall Street Journal. Over the years, companies in the index have been changed to ensure the index stays current in its measure of  the  U.S. economy. In fact, of the initial companies included, only General Electric remains as part of the modern-day average.

DJIA Complications
As you might have guessed, calculating the DJIA today isn't as simple as adding up the stocks and dividing by 30. Dow lived in times when  stock splits (for more on stock splits, click here) and stock dividends weren't commonplace, so he didn't foresee how these corporate actions would affect the average.

For example, if a company trading at $100 implemented a 2-for-1 split, the number of its shares doubles, and the price of each share becomes $50. This change in price brings down the average even though there is no fundamental change in the stock. To absorb the effects of price changes from splits, those calculating the DJIA developed the Dow divisor, a number adjusted to account for events like splits that is used as the divisor in the calculation of the average.

How Does  the Dow  Divisor  Work?
To calculate the DJIA, the current prices of the 30 stocks that make up the index are added and then divided by the Dow divisor, which is constantly modified.

To demonstrate how this use of the divisor works, we will create a mock index, the Investopedia Mock Average (IMA). The IMA is composed of  10 stocks, which total $1,000 when their stock prices are added together. The IMA quoted in the media is therefore 100.00 ($1,000/10). Note that the divisor in our example is 10.

Now, let's say that one of the stock in the IMA average trades at $100 but undergoes a 2-for-1 split. Its price then reduces to $50. If our divisor remained unchanged, the calculation for the average would give us 95.00 ($950/10). This would not be accurate because the stock split merely change the price, not the value of the company. To compensate for the effects of the split we have to adjust the divisor downward to 9.5. This way, the index remains at 100.00 ($950/9.5) and more accurately reflects the value of the stock in the average.

If you are interested in finding the current Dow divisor, you can find  it at the website of the  Dow Jones Indexes and the Chicago Board of Trade.

And How Does  the DJIA Number  Translate into a Dollar Value?
To figure out how a change in any particular stock affects the amount the index changes, up or down,  divide the stock's price change by the current divisor. For example, if General Electric was up $5, divide 5 by 0.14418073, which equals 34.68. Thus, if the DJIA was up 100 points on the day, GE was responsible for 34.68 points of the move.

Conclusion
The DJIA's methodology of calculating an index is known as the price-weighted method. On top of having to deal with stock splits, the downside to this method is that it does not reflect the fact that a one dollar change for a $10 stock is much more significant (percentage wise) than a one dollar change for a $100 stock. Because of price-weighting's associated problems, most all other major indexes such as the S& P 500 are market-capitalization weighted

That being said, despite all the shortcomings, the Dow is still one of the most watched indicators of stock market performance.

History of the DJIA
Dow Jones & Co. was founded in 1882 by Charles Dow, Edward Jones and Charles