Why Apple Doesn't Belong in the Dow

The Dow Jones Industrial Average stinks.

If it were up to me, I'd ignore it altogether. Unfortunately for me, ignoring it isn't a practical option, considering how much everyone else focuses on and quotes the 115 year-old index. My first problem with the index is how narrow its scope is. It tracks only 30 stocks out of the thousands that are out there, compared with the S&P 500, which tracks, well, 500 stocks.

My second and bigger problem regards its methodology. The Dow is price-weighted, whereas essentially all other major indices are market cap-weighted, including the S&P 500, Nasdaq Composite, and Russell 2000. Overall market caps are much more relevant than individual share prices are, which is one reason stock splits are nothing special. A stock split has no effect on a company's overall market cap, and therefore no effect on market cap-weighted indices, yet a stock split definitively will affect the individual share price and consequently change the weighting of a price-weighted index like the Dow.

Part of the Dow's calculation does include a divisor that has been adjusted over the years. But the divisor's adjustments are intended only to "preserve historical continuity" throughout corporate actions such as splits, spinoffs, and substitutions. That way, the numerical value of the index doesn't suddenly change by virtue of such an event. However, the composition and weighting will change after the event, even though the transition appears seamless thanks to the divisor's adjustment. The divisor is currently 0.132129493.

It's all about perspective
This is why Apple (NAS: AAPL) doesn't belong in the Dow. The topic rears its silly head periodically, only to be promptly shot down because of the Dow's weaknesses. Earlier this week, there was some renewed speculation that Apple would join the ranks of the Dow as the stock rose to all-time highs.

Right now, IBM (NYS: IBM) is the highest-priced and most heavily weighted component, closing in the neighborhood of $169 yesterday with a market cap of around $202 billion. In contrast, Bank of America (NYS: BAC) is the lowest-priced and least weighted component, closing near $6 with a market cap of $64 billion. So even though IBM's market cap is just over three times B of A's, it's given 28 times the weighting because of the dramatically different share price.

Another example of the absurdity would be to compare Cisco (NAS: CSCO) and General Electric (NYS: GE) , both of whose shares closed right around $15 yesterday -- giving them equal weight -- but GE's $159 billion market cap dwarfs Cisco's $83 billion.

Now imagine if you were to add Apple into the mix with its $404 price tag. It just wouldn't be fair for the little guys. It would disproportionately affect the index's movements, as it's more than twice IBM's share price, which is already overweight since second place goes to Chevron's (NYS: CVX) $90 shares.

To an extent, Apple does deserve greater weight as the largest company in the world by market cap. Standing at $372 billion, it recently dethroned Dow member Exxon Mobil (NYS: XOM) , which now sits around $337 billion.

Even though Apple merits more sway, it shouldn't carry that much influence.

They don't split 'em like they used to
Apple has had three separate 2-for-1 splits: June 1987, June 2000, and February 2005. People have been asking for another Apple stock split for years, but in practice no one should care anymore. Ignoring psychological oddities like a predisposition for larger share quantities and the antiquated practice of purchasing only in round lots, there's no compelling reason for or against splits.

Steve Jobs has enough to worry about -- for example, his health. He shouldn't be concerned with investors who think they can't afford the shares solely because they prefer the sound of a round 100 shares at $200 instead of buying "only" 50 shares at $400.

It's true that if Apple were to split, it would see much greater prospects of inclusion in the Dow, and the index would get to benefit from Apple's performance. But why should Apple's board go out of its way just for the possibility of getting in on and boosting an outdated index?

The status quo
As it stands, Apple has virtually no chance of displacing a company from the Dow Jones Industrial Average. The flawed way that the Dow is calculated arbitrarily diminishes the chances of including any stock that sees dramatic outperformance without splitting its shares.

The Dow may be missing out on Apple, but Apple isn't missing out on the Dow.

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At the time thisarticle was published Fool contributorEvan Niuowns shares of Apple, but he holds no other position in any company mentioned. Check out hisholdings and a short bio. The Motley Fool owns shares of Apple, Bank of America, and IBM, and Cisco and has created a bull call spread position on Cisco Systems.Motley Fool newsletter serviceshave recommended buying shares of Chevron, Apple, and Cisco and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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