What Is an Index Divisor?
An index divisor is a number chosen at the inception of a price-weighted stock market index which is applied to the index to create a more manageable index value. When an index is created, be it a price or market cap weighted index, the prices of the index constituents are added together to create the initial starting value of the index. The divisor is applied to bring the seemingly random number that is the sum of all the constituents to a round, memorable number which is easier to remember and track, such as 100. Once the index divisor is established, it is not changed.
- An index divisor is a standardization figure used to compute the nominal value of a price-weighted market index.
- The divisor is used to ensure that events like stock splits, special dividends, and buybacks do not significantly alter the index.
- Some divisors, such as the one used to normalize the Dow Jones Industrial Average, are updated regularly.
How Index Divisors Work
An index divisor gives an investor or observer an easy way to track the value of an index over time. The divisor mechanism allows people to easily track the value of the index by looking at the quotient of the index value divided by the index divisor. However, the divisor may need to be adjusted if there are material changes to the index which affect its value, such as if a constituent leaves the index or the company repurchases shares or has a rights offering.
There are different ways an index can be constructed. In a price weighted index, the price of a single share of each constituent is added to the index. The individual share prices of all constituents added together create the initial starting value of the index. If it is an index of large pharmaceutical companies, there might be 20 companies and each of their share prices when added together might equal 476. This is an awful number to remember. An index divisor of 4.76 is created to bring the trackable value of the index down to 100. Over time, it is easier to remember an index starting value of 100 and judge whether or not the value of the index has risen or fallen.
A market capitalization weighted index computes its value differently—by taking the share price of a constituent and multiplying it by the number of shares outstanding. The resulting product values of all constituents are then added together. Once the process is complete, the resulting index value may be an odd and unmemorable number such as 6,873. This would be assigned an index divisor like 68.73 or 6.873 to bring the trackable value of the index down to a round 100 or 1000.
Example of an Index Divisor
The Dow Divisor is a numerical value used to calculate the level of the Dow Jones Industrial Average (DJIA). The DJIA is calculated by adding up all the stock prices of its 30 components and dividing the sum by the divisor. However, the divisor is continuously adjusted for corporate actions, such as dividend payments and stock splits.
If the sum of the prices of the 30 constituents of the DJIA is 4,001, dividing this figure by the Feb. 8, 2021 Dow Divisor of 0.152 would provide a level of 26,322 for the index. Using this divisor, every $1 change in price in a particular stock within the average equates to a 6.5 (or 1 / 0.152) point movement.