How Stock Market Averages Work
Among the several types of stock market averages are price-weighted and capitalization-weighted indexes. The former is calculated by dividing the sum of all stock prices by a predetermined number, while the latter requires working out each component company's value and weight first. Most people believe that a capitalization-weighted index better reflects the state of the market.
Other People Are Reading
-
Price-Weighted Index
-
A price-weighted index is calculated by working out the sum of all component stock prices and dividing them by a divisor. The company that publishes the index sets the divisor. When the index is first calculated, the divisor may be set to give a simple round figure, say 1,000, which would serve as a starting point. The company can later adjust it, if the number of shares floated by listed companies changes significantly.
Criticism
-
In a price-weighted index, such as the Dow Jones Industrial Average, stock's influence on the overall value is proportional to its price. This means that a $2 stock weighs -- influences the index -- twice as much as a $1 stock. This in itself shouldn't be a problem if all companies included in the index had the same number of outstanding shares trading. But that's hardly ever the case. If a company trading at $2 per share has 2,000,000 shares outstanding, and a company trading at $1 per share has 4,000,000 shares outstanding, that means the $1 company is worth twice as much. However, their influence on the index remains the same, which is why, as some people believe, a price-weighted index does not reflect accurately the changes in the market.
-
Capitalization-Weighted Index
-
Capitalization-weighted indexes try to solve this problem by giving component stocks different weight based on their companies' market capitalization -- the total amount of money needed to buy all their outstanding shares. S&P 500, NASDAQ and Dow Jones Wilshire all belong in this category. This type of index is calculated by working out the market capitalization of each component. This means multiplying the number of outstanding shares -- those available to buy -- by the company's current share price. All these individual values together give the index's overall market capitalization. When a company's stock price moves up, say by 2 percent, we divide the weight by 2 and get a percentage by which this stock influences the overall change in the index.
Nasdaq 100
-
Although a capitalization-weighted index seems to be more balanced than the price-weighted one, large price movements in the largest components can have a big effect on the index. That is why indexes such as NASDAQ 100 adjust the weight of individual stocks based on various added criteria.
Fundamentally-Weighted Index
-
Some investors believe that stock price and market capitalization are not always the best indicators of a company's value, health and potential. They use various other indexes that track company's cash flows, dividends, revenues and profits. These are known as fundamentally-weighted indexes.
-
