Stock Market Indexes

Stock Index
A collection of stocks that are used to assess the performance of an economy, market, or
specific sector
What is a Stock Index?
A stock index, also called a share index or stock market index, consists of constituent stocks
used to provide an indication of an economy, market, or sector. A stock index is commonly used
by investors as a benchmark to gauge the performance of their portfolio. Examples of stock
indexes include the Dow Jones Industrial Average (DJIA), the Nikkei Stock Average, the S&P 500,
the Nasdaq Composite, and the Wilshire 5000.
Stock Index Composition
A stock index is comprised of constituent stocks that, when pooled together, provides an
indication of something. For example:
 The Dow Jones Industrial Average comprises 30 of the largest and most influential
companies; and
 The S&P 500 consists of the top 500 U.S. stocks by capitalization.
The Dow Jones Industrial Average and S&P 500 are used in mass media to provide a broad
indication of economic performance in the United States.
Stock Index Weighting
Stock indexes can follow different weighting methods, such as a:
 Price-weighted index;
 Modified price-weighted index;
 Market capitalization-weighted index;
 Market capitalization-weighted index adjusted for float; and
 Equally-weighted index.
For example:
 The Dow Jones Industrial Average is a price-weighted index; and

 The S&P 500 is a market capitalization-weighted index.
The weighting method used carries implications on the performance of an index.

Price-Weighted Index
A stock market index wherein each component is weighted according to its current share price
What is the Price-Weighted Index?
A price-weighted index is a type of stock market index in which each component of the index is
weighted according to its current share price. In price-weighted indices, companies with a high
share price have a greater weight than those with a low share price. Therefore, the price
movements of companies with the highest share price have the largest impact on the value of
the index.
Nowadays, price-weighted indices are less common than other indices. Instead, the
capitalization-weighted index is the most prevalent form of market indices. The biggest price-
weighted indices are the US Dow Jones Industrial Average (DJIA) and Japan’s Nikkei 225.
A price-weighted index is often criticized because it considers only the price of each component
as the driver of the index value. Therefore, even a small price fluctuation in a higher priced
company may significantly affect the value of the index.
How to Calculate the Weights in a Price-Weighted Index
The weight of a individual component is calculated by dividing its price by the sum of all the
components’ prices. Mathematically, it is expressed in the following way:
Let’s consider the following example. The PWI Index is a price-weighted index that includes the
stocks of four companies. The information about the companies included in the index can be
found in the table below:
Using the formula above, we can calculate the weight of each index component:
How to Calculate the Value of a Price-Weighted Index
In theory, the value of the index can be determined as an arithmetic average by dividing the
total sum of the prices of the components in the index by the number of the index components.
However, such an approach is not usually encouraged because events such as spinoffs, stock
splits, and mergers affect the composition of the index.
In reality, the value of a price-weighted index is calculated by dividing the total sum of the
prices of the index components by the divisor. The divisor is an arbitrary value computed by the
index and adjusted for various structural changes in the index components.
For example, the Dow Jones Industrial Average, which is the most prominent price-weighted
index, calculates its own divisor (Dow divisor). The Dow divisor changes over time to better
match the existing composition of the index.
Capitalization-Weighted Index
A stock market index wherein each component is weighted relative to its total market
capitalization
What is the Capitalization-Weighted Index?
The Capitalization-Weighted Index (cap-weighted index, CWI) is a type of stock market index in
which each component of the index is weighted relative to its total market capitalization. In a
capitalization-weighted index, companies with larger market capitalization exert a greater
impact on the index value. Companies with a smaller market capitalization carry less
significance.
The capitalization-weighted index is currently the most common stock market index. The
largest and most prominent market indices – including S&P 500, the NASDAQ Composite, and
the FTSE 100 – are capitalization-weighted indices.
Breaking Down the Capitalization-Weighted Index
Capitalization-weighted indexes are widely used because the values change proportionally to
the price changes of each component (since market capitalization is determined by the stock
price multiplied by the number of shares outstanding). The indices also consider the
shareholder base of each component.
Since some companies own shares that are not fully available to the public, most of the indices
use the free float factor to adjust calculations. The free float is the percentage of the shares
available for trading.
Some investors criticize capitalization-weighted indexes for providing a distorted view of

the stock markets. Many believe that the primary reason for the distortion is the overweighting
toward companies with the largest market capitalization.
Example of How to Calculate a Capitalization-Weighted Index
The CWI Composite is a capitalization-weighted index. It consists of four companies only:

Company A, Company B, Company C, and Company D. The summary of the current stock prices
and the total number of the shares outstanding for each company is given in the table below:
Using the information from the table above, we can calculate the market capitalization of each
index component. The market capitalization can be found through the following formula:
Market Capitalization = Stock Price x No. of Shares Outstanding
Thus, the market capitalization of each company in the index is:
 Company A = $5 x 5,000,000 = $25,000,000

 Company B = $10 x 1,000,000 = $10,000,000
 Company C = $25 x 500,000 = $12,500,000
 Company D = $15 x 1,500,000 = $22,500,000
The total market capitalization of the index is the sum of the market capitalization of all the
components. Therefore, the market capitalization of the CWI Composite is:
CWI Composite = $25,000,000 + $10,000,000 + $12,500,000 + $22,500,000 = $70,000,000
The weight of each index component is determined using the formula below:

Stock Market Indexes

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Stock Index

What is a Stock Index?

Stock Index Composition

Stock Index Weighting

Stock indexes can follow different weighting methods, such as a:

 The Dow Jones Industrial Average is a price-weighted index; and

The weighting method used carries implications on the performance of an index.

What is the Price-Weighted Index?

How to Calculate the Weights in a Price-Weighted Index

How to Calculate the Value of a Price-Weighted Index

What is the Capitalization-Weighted Index?

Breaking Down the Capitalization-Weighted Index

Some investors criticize capitalization-weighted indexes for providing a distorted view of

Example of How to Calculate a Capitalization-Weighted Index

The CWI Composite is a capitalization-weighted index. It consists of four companies only:

Market Capitalization = Stock Price x No. of Shares Outstanding

Thus, the market capitalization of each company in the index is:

 Company A = $5 x 5,000,000 = $25,000,000

CWI Composite = $25,000,000 + $10,000,000 + $12,500,000 + $22,500,000 = $70,000,000

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