HOW ARE STOCK INDICES FORMED?

An index consists of similar stocks. This could be on the basis of industry, company size, market capitalization or another parameter. Once the stocks are selected, the index value is calculated. This could be a simple average of the prices of the components. In India, the free-float market capitalization is commonly used instead of prices to calculate the value of an index.
The two most common kinds of indices are – Price-weighted and market capitalization-weighted index.

What is stock weightage?

Every stock has a different price. So, a 1% change in one stock may not equal a similar change in another stock’s price. So, the index value cannot be a simple total of the prices of all the stocks. Here is where the concept of stock weightage comes into play. Each stock in an index has a particular weightage depending on its price or market capitalization. This is the amount of impact a change in the stock’s price has on index value.

Market-cap weightage

Market capitalization is the total market value of a company’s stock. This is calculated by multiplying the share price of a stock with the total number of stocks floated by the company. It thus takes into consideration both the size and the price of the stock. In an index using market-cap weightage, stocks are given weightage on the basis of their market capitalization in comparison with the total market-capitalization of the index. For example, if stock A has a market capitalization of Rs. 10,000 while the index it is part of has a total m-cap of Rs. 1,00,000, then its weightage will be 10%. Similarly, another stock with a market-cap of Rs. 50,000, will have a weightage of 50%.

The point to remember is that market capitalization changes every day as the stock price fluctuates. For this reason, a stock’s weightage too changes every day. However, it is usually a marginal change. Also, the market capitalization-weightage method gives more importance to companies with higher m-caps.

In India, most indices use free-float market capitalization. In this method, instead of using the total shares listed by a company to calculate market capitalization, only the amount of shares publicly available for trading are used. As a result, free-float market capitalization is a smaller figure than market capitalization.

Price weightage

In this method, an index value is calculated on the basis of the company’s stock price, and not market capitalization. Stocks with higher prices have greater weightages in the index than stocks with lower prices. The Dow Jones Industrial Average in the US and the Nikkei 225 in Japan are examples of price-weighted indices.

There are also other kinds of weightages like equal-value weightage or fundamental weightage. However, they are rarely used by public indices.

HOW IS INDEX VALUE CALCULATED?

An index’s value depends on whether it is a price-weighted index or market cap-weighted. Let us take the example of the BSE Sensex to understand how an index is calculated.