Assessing the value of a company or security can take a few different forms. You can measure all stocks or securities equally, or use market capitalization. Another choice: a price-weighted index, in which each member company’s stock in an index is weighted proportionally to its current share price.
How to Calculate a Price-Weighted Index
In a price-weighted index (PWI), companies with a high share price are more valuable than companies with a low share price. The higher the share price, the bigger the impact on the index value.
To find the weight of a particular component of an index, divide its price by the sum of all the components in the index, which looks like:
Weight = P1 + P2 + P3 / P1 x 100%
The formula is similar to calculating the percentage of a regular number. Here’s an example:
- Company 1 share price: $10
- Company 2 share price: $20
- Company 3 share price: $30
- Company 4 share price: $40
To find the weight of Company 1, you would do the following:
$10 + $20 + $30 + $40 / $10 x 100% = 10%
And here’s the breakdown for Company 2:
$10 + $20 + $30 + $40 / $20 x 100% = 20%
$10 + $20 + $30 + $40 / $30 x 100% = 30%
$10 + $20 + $30 + $40 / $40 x 100% = 40%
As you can see from this example, Company 4 has the highest price-weighted index.
The Dow Jones Industrial Average (DJIA) is a type of price-weighted index that currently measures the stock performance of 30 large companies. But this index is calculated a bit differently. Here, you add up the stock prices of the Dow’s 30 components, then divide that sum by the “divisor,” a number that changes regularly depending on what’s happening with the 30 stocks.
Why a Price-Weighted Index Matters
In a PWI, stocks with higher prices have more weight without regard to the company size or other factors, like outstanding shares.
A major feature of a PWI is that larger companies will always have the biggest impact, even if they grow only a little bit. In the example above, Company 4 above has the greatest impact at 40%. If its price rises from $40 to $45, it will still have more impact than if Company 1 went from $10 to $20, because the overall percentage — and not the change itself — is greater. For the DJIA, the higher-priced stock affects the index more than companies with lower prices, even if the change among the lower prices is more significant, percentage-wise.
Along those lines, if the larger company grows slower and smaller companies decline at the same time, the index can still increase.
What Do Other Indexes Look Like?
The PWI is only one type of index. There are other ways to measure indexes, both weighted and unweighted.
This type of market index weighs individual securities according to their total market capitalization. Market capitalization — or simply, “market cap” — multiplies the total number of outstanding shares a company has by the current market price of one share.
Larger growth for higher market cap companies can significantly impact the overall index. Even steady growth for large index companies can be good as well, especially if lower index companies aren’t as stable. It also means that when share prices of a larger company drops, it has less of an impact on the index than if the same were true for a company with a lower weight — even if their drops are similar in percentage.
To calculate a cap-weighted index, multiply the market price by the total number of outstanding shares. Take the total market value of each company and divide it by the entire market value.
The higher the market cap, the higher the percentage a company weighs in an index. Smaller market caps mean lower weights in the index. The S&P 500 Index and Nasdaq Composite Index are both capitalization-weighted.
Fundamentally Weighted Index
This type of index weighs components on fundamental criteria instead of market capitalization. Metrics can include:
- Book value
- Dividend rates
These securities are based on a set of fundamental characteristics and are common in customized tracking indexes used by passive management firms. So depending on the fund company you go with, the fundamentally weighted index could be calculated differently.
An unweighted index gives equal weight to all securities in an index. These aren’t as common since most indexes come from market capitalizations, which means there’s weight behind those calculations.
The Bottom Line
One type of index isn’t necessarily better than the other; all indexes show different things, depending on how you look at them.
While market capitalization might be a popular measure for indexes, you can look at other measurements too, like a fundamentally weighted index or even an unweighted index. To get a holistic view of how well (or badly) a stock or security is performing, use many different types of indexes to measure it.
Tips for Investing
- If you’re a passive investor and use a robo-advisor, you might already be using fundamentally weighted index measurements and not even know it. Before you decide to make the jump from one index to another, see which one you’re already using. If you research and find that your current index is working out for you, keep it. Otherwise, be open-minded to using a variety of different indexes to take the true measurement of a stock or security.
- Managing your money solo is a good way to get into investing, but it’s not the only way. If you have a variety of investments, or you’re looking for specific investing advice, it might be time to level up. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in just 5 minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
Photo credit: ©iStock.com/Chainarong Prasertthai, ©iStock.com/Vertigo3d, ©iStock.com/PeopleImages