What Is Capitalization Weighted Index?
Capitalization weighting is one method used to calculate the value of a stock market index. Stock indexes track the share price changes of a selected group of stocks. Widely followed stock indexes include the Dow Jones Industrial Average, which is not capitalization weighted, and the S&P 500, which is.
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Market Capitalization
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The market capitalization of a company is the current share price times the number of shares the company has outstanding. The market capitalization -- market cap -- is what a company is worth. Someone could write a check for that amount, buy all the shares and own 100 percent of the company. Market caps of individual companies range from a few million dollars for micro-cap stocks to over $300 billion for giant corporations like Exxon-Mobil and Apple.
Index Methods
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Several processes calculate the value of a stock market index. A share price weighted index, in it simplest form, is just an average of the share prices in the index. Higher priced stocks have greater representation and influence on the index value than low priced stocks. An equal-weighted index gives equal value to every share tracked and each stock has the same influence on the index value. Market capitalization weighting gives larger representation to stocks with larger market caps, in proportion to their overall market value.
Effects of Market Cap Weighting
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A market cap weighted stock index most accurately reflects the value of the portion of the stock market covered by the stocks in the index. Larger cap stocks comprise more of the overall market's value and have more influence over price changes in the index. A $1 price change in the largest stock in an index will have a much greater effect than the same share price change from the smallest stock by market value. For example, of the 500 stocks in the S&P 500 stock index, the 10 largest stocks make up 18.5 percent of the index's value.
Major Indexes
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Market capitalization weighting is the most widely used method for stock index valuations. The S&P 500, NASDAQ composite, NASDAQ 100 and the NYSE Composite Index are all market cap weighted indexes. The only major market index not market cap weighted is the Dow Jones Industrial Average, which is share price weighted. The DJIA was created as a simple share price average over 100 years ago and has stayed a price weighted average. Equal value indexes are rarely used except as target indexes for specialty exchange traded funds -- ETFs.
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