 Welcome to this session. This is Professor Farhad in which we would look at the DAO industrial average, which is a price weighted index. We're gonna look at how it's computed, its weakness and its strength. This topic is covered in an essential of investment course or principles of an investment course, undergraduate or graduate. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lessons, please like them, share them, put them in playlist. If they benefit you, it means they might benefit other people, connect with me on Instagram. On my website, farhadlectures.com, you will find additional material to supplement your education, whether you are studying finance or accounting or studying for your CPA or CMA exam. So what is the DAO and the DAO Jones industrial and what's the purpose of it? Basically, the purpose of it is to look at a single index and engage the strength or the weakness of how well we are doing in the economy. That's the purpose of the industry, as one number tells you what's going on in the economy. When, how was it created? It was created by two individuals, Charles Doe and Edward Jones, which this was a newspaper editor and a statistician. And what they did back then in the 1800, late 1800, they combined the 12 industrial companies at that time as a single tool, as a single gauge to measure the performance of the economy. Now, obviously now the DAO is not 12, the DAO is 30 companies, 30 blue chip corporation, but it started at 1896. At some point it was only 20 companies up until 1928. So the DAO originally, historically, when it first started was calculated as the average price of the stocks included in the index. Simply put, you'll take the stocks included, the price of the 30 stocks divided by 30. And this is how you find how well the DAO industry, how well the DAO doing or how bad it's doing. So the value of the portfolio, so if you have hold one share of stock in this index is the sum of the 30 prices because it's a simple average, okay? Because any change, because the percentage change and the average of the 30 prices is the same as the percentage change in the sum of the 30 prices. Therefore, the index and the portfolio had the same percentage and change each day. So the amount of the money that you invested, let's assume you invested some money in each company in that portfolio is proportional to the company share price. So that's why we say it's an important thing to remember that the DAO is a price weighted average. So the first thing we're gonna do is we're gonna look at a simple. When the DAO was created, what do we mean by price weighted average and how is the price weighted average is computed today? So I'm gonna take you to the Excel sheet and work a simple example to start our exploration. To illustrate this concept, let's assume we have an index and we only have two companies. So rather than 32 companies, ABC company and XYZ company, we have the beginning price and the ending price. For ABC, it started at 25, went up to 30. The change in ABC company is $5. The percentage change, which is five divided by the beginning price, the percentage change is 20%. So ABC went up 20%. XYZ company, the beginning price is 100. The ending price is 90. Therefore, XYZ stock went down by $10. They went down by 10%, 100 divided by, 10 divided by 100 equal to 10%. Now let's take a look at the overall portfolio, the beginning balance, the beginning value of the stocks is 125. The ending value is 120. The change is negative five and the change is negative 4%. This is for the portfolio. Let's find the average. The average is basically we have two stock. So we're gonna take 125 divided by two and the ending is 120 divided by two. Same thing, we're gonna find the difference between the two, the average prices and obviously the average of this index, the average of the index is 4%, just like with the performance of the portfolio. Now the first thing I want you to notice is this. Although one stock, ABC company went up 20%. Notice the stock went up substantially. You should be like, wow, this is a huge performance. Okay, went up 20%. And the other stock went down 10%. Overall, the portfolio went down 4%. So how is that possible? Where it's possible because it's price weighted index. Why, what do you mean by price weighted? It means if your stock price is higher, it's gonna affect the overall return of the portfolio because you are computing the overall based on the price. The first thing you wanna know is about the Dow, it's price sensitive. So the higher the stock price is in the Dow, the higher is the effect on the Dow, on the Dow industrial average. Okay, so this is, but basically this is a simple illustration just to show you what's happening. So if you're saying that's the case, let's take a look at a sample Dow. So those are the 30 companies in the Dow industrial. Let me just make it a little bigger. So those are the 30 companies, Pfizer, McDonald, Intel, all of them. And this is the closing price of June 16th, 2020. So if we add up all the prices, they all add up to 3,833, but the average price, if we take this number divided by 30, the average price is 127,77. Well, the Dow closed at, the Dow closed at 26,190. So the question is why if it's price weighted should be 127,77. Why did it close at 26,190? So you might be wondering why in June if it's average price, why is it that much? The reason is it's no longer the average price of all 30 stocks are equal. So you no longer divide by 30. The divisor, what you do, the divisor changes. When does it changes? It changes over the years. When there's a stock split over the years, when a company pays a 10% or more in stock dividend, or when when company leaves the Dow and it's replaced by another company. And that happens on a regular basis because remember those 30 companies in the Dow, they have to represent the economy. When a company becomes irrelevant to the economy, we have to remove it and replace it by a company that reflect what's going on in the economy. So let's go back to this example, ABC and XYZ company. And let's assume the following just to kind of illustrate the point. So XYZ company, XYZ and ABC, ABC is still in the same position. We're not gonna change anything for ABC company. The beginning price is 20, the ending price is 30. However, XYZ had a two for one split. It means for every share they gave you two. When that happens, it means your stock will be cut in half. Therefore, XYZ price is adjusted rather than 100. Now the price is 50. Why? Because again, we had a stock split and for every one share they gave you two, therefore the stock price is adjusted. Also, the ending price is adjusted as well. Therefore, rather than 90, the ending price is 45. Now let's take a look at the dollar difference. The dollar difference now is $5. And if we find the percentage difference, the percentage difference is 10%, which is the same, 10%. Now let's find the total. Let's find the total. Simply put, we'll take 25 plus 50 because now this is the new total. And the ending total is 30 plus 45. Notice what happened now. The change overall for the total portfolio is zero. And if the change is zero, the percentage is zero. Now let's find also the average for the index based on these averages, based on the two stocks average. And what's gonna happen is the average is 75 divided by two and 75 divided by two. Therefore, the average, the change is zero and the change is zero. So notice what happened. Nothing really happened to the economy in a sense that the economy is better off or worse off. All what happened went from 4% reduction from the beginning of the period till the end to an improvement to zero. No change in the stock. No change in the index. It means it's an improvement. It means if you invested in the Dow, now you are at no loss before you were at a loss of 4%. Now why did this happen? This happened simply because this stock price, X, Y, Z, the company decided to do a stock split. Now when this happens, when this happens in the real world, yes, the index would reflect a zero change because that's exactly what happened. And this is one of the weaknesses in the Dow that it's price sensitive. So this change is correct. But what we have to do, we have to find a new divisor. So the divisor is no longer two, remember here. So how do we find the new divisor? We have to go back to this number. We have to go back to this divisor of 62.5. This way we are comparing oranges to oranges. So what's gonna happen going forward, we have to find the new divisor. Now how do we compute the new divisor? Very simple. We're gonna take 25, 25 plus 50, 25 plus 50. And we're gonna divide 25.50 divided by D, which is the unknown. And that's gonna give us 62.5, which is the beginning average. Well, if we divide, we're gonna get the divisor now is 1.2. Simply put, when I go to compute my new average, I'm gonna take cell D9 divided by 1.2, my new divisor, and take D10 divided by 1.2, that's my new divisor. Yes, my return still zero. However, my divisor changed for the future. So in the future, if I still have those two portfolio, when there's any changes, when I compute the average, I compute my new divisor. And this new divisor is constantly changing, is constantly changing for the DAO. For example, this divisor for the DAO was 0.145 in 2018. Now, let me show you the new divisor. As of June, as of June 16, I computed, I added up all the prices for the DAO, 3833, and the DAO closed that day, DAO closed that day for $26,190 at $26190. It means the divisor is 1.46. So we're gonna be working with this divisor to show you. So the divisor now is 0.146. Why is it 1.46? Because over the years, this divisor has been adjusted for stock split, stock dividend, and when one company leaves, the DAO and another company is replaced. So let's show you the price sensitivity of it. So to show you the price sensitivity, what I did is I graphed all the prices of the DAO, and notice Apple here has a high price versus Pfizer, which have a low price. So let's assume on June 17th, which is on June 17th, the following happened. So I'm gonna change once one variable at a time to illustrate the point. So let's assume on June 17th, all the, so remember the index closed at $26190, $26190, and let's assume only one thing changed. And that thing is Apple was $352. Remember Apple has a high price in the DAO, and it went up 2%. So I'm gonna change Apple from $352.08, and I'm gonna multiply it by, the price went up on June 17th, the following day by 2%. So the price, multiply by, let me change, let me fix this. Okay, now it's fixed, multiply by 1.02. Now the price of Apple is rather than 352, 359. Let's see what happened to the price of the DAO. The DAO went from $26190, $26190 to $26238. So notice by 0.02, 2% of the DAO, so let's find the, let's find the change, 26, 238 minus 26190, the DAO went up 48 points, okay? Just by increasing Apple by 2%, okay? And the percent increases 0.18 as far as percentage, okay? And 0.18%, so this is for Apple. So let's go back and put Apple, go back to Apple to 352, and what I'm gonna do, rather than changing Apple, I'm gonna increase Pfizer, I'm gonna increase Pfizer by 2%. So Pfizer was $33.40, I'm gonna multiply it by 1.02, increase Pfizer by 2%. And what happened? I'm using the same divisor now. So notice, notice now the DAO went up by 4.65 points. So notice with Pfizer, the same percentage, only four points, I went up to $26194, with Apple, it went up by 48 points, okay? So notice the difference, notice the difference, why? Because Apple, the DAO is price sensitive, it's price weighted, so the stock with the higher price, stock with the higher price, it's gonna affect the index on a larger scale. So that's what we mean by price sensitive. And this is one problem with the DAO, it's price sensitive, okay? And kind of a nice, not my story, the real story is, Apple, before they joined the DAO, they had a $700 price or around $700, what they had to do, they had to do seven for one split. So what they did is, if you had, I remember I did have some Apple shares, if I had 700 shares of Apple, I wish I did, but let's assume I had 700 shares of Apple, I woke up the next day, actually I had more, if I had, let's assume I had 100 shares of Apple, if I had 100 shares of Apple at $700, I woke up the following day, so those are the shares, I woke up the following day and I had 700 shares, but the price was 100. Why did Apple had to do this split? Apple had to do the split because if they joined the DAO and they had a price of 700, they would have had a great effect on the DAO. Now, although they went down to 100, now they're back to 350, I could assure you, if Apple keeps on going up to like 400 or 450, the DAO will ask them to do a split. Why? Because when your price is very high, you will affect the index much heavily. So that's what we're trying to say by price weighted index. Take a look at sample companies. For example, I do remember when Apple was added to, to the DAO industrial. Why? Because I used to care, I used to have that as I told you, I had Apple stocks and it replaced North American. There was a big deal that GE was the company that survived since 1928, but guess what? GE was replaced a couple of years ago. It was replaced by Walgreen, a pharmaceutical company. So although GE everybody would say, oh, GE was always been of the DAO, even GE is gone. All the DAO original from 1928, they're all gone. For example, Sears Reebok is replaced by Home Depot. GM is replaced by Intel. Chrysler was replaced by IBM, so on and so forth. And they'll tell you the industry. So you have to be very, again, you have to be very careful because you're only selecting 30 companies, 30 companies to do what? To reflect everything that's going on in the economy. And that's what's gonna take us next to the next topic to talk about the S&P 500. For one thing, it's 500 companies. It has its own disadvantages. We'll talk about them in a moment. And in the next session, but the point is rather than 30 companies, you're looking at 500 companies. And it's market value weighted index versus a price weighted index. So this is the next topic. So if you like this recording, please like it, share it. If it benefits you, it means it might benefit other people. As always, I would like to remind you to visit my website, farhatlectures.com for additional resources. If you are studying for your CPA, CFA exam, study hard, invest in your career, success is worth it. Good luck.