• # Market Index Creation Methodology

There are mainly three types of Market index creation methodologies. All of these are explained below.

1. Price Weighted:
2. Market Capitalization weighted:
3. Free Float Method:

Preparation of stock market index

Price-weighted index

Price-Weighted index is calculated based on the arithmetic average of current share prices. For price weighted index, the index can be replicated by buying the same number shares from all the contributing companies. Dow Jones Industrial Average (DJIA) is the most famous price weighted index.

Price Weighted Index = (Total sum of all the share prices of the contributing companies / number of stocks used to generate the index)

Example

Let us see the below example to understand the basics of price weighted index

• Suppose there are 5 stocks in the index. At the time of creating the index, their prices were USD 300, 220, 100, 50 and 20.
• The average or the price weighted index was ( 300+220+100+50+20) / 5 = 138
• Suppose after 1 year the share prices become USD 330, 240, 110, 52 and 25 respectively.
• The price weighted index after 1 year will be (330 + 240 + 110 + 52 + 25)/5 = 151.4; which is an increase of nearly 10% compared to last year index.
• Let’s consider after 1 more year the prices become USD 370, 220, 115, 60, and 30 respectively.
• So at that time the price weighted index will be (370 + 220 + 115 + 60 + 30)/5 = 159; which is an increase of nearly 5% in last one year.

From the example we can see that the higher value shares are having the highest impact on the price-weighted index. The base is revised for any stock split or bonus issue because of change in share prices.

The main disadvantage of this methodology is that the index is mainly dependent on the highly value share prices which dominates the index changes significantly.

Market value weighted index

Market weighted index is calculated based on the total market capitalization or the market value of the contributing stocks. Nifty is widely recognized as market weighted index.

Market Weighted Index = (Sum of market capitalizations of all the stocks / sum of market capitalization of all the stocks at the base time) * Index’s base value.

Example

Let us see the below example to understand the basics of price weighted index

• Suppose there are 5 stocks in the index. At the time of creating the index, their prices were USD 300, 220, 100, 50 and 20 and the total numbers of shares are 2000, 1800, 1500, 1700, 2500 respectively.
• At the time of base index creation, the market caps of all these 5 listed companies are Rs 600000, 396000, 150000, 85000 and 50000 respectively.
• The weight of the first company in the overall index is nearly 47%.
•  The average or the market weighted index at the time of creation was (600000 + 396000 + 150000 + 85000 + 50000)/ 5 = 256200
• Suppose after 1 year the share prices become USD 330, 240, 110, 52 and 25 respectively.
• So after 1 year the market caps of all these 5 listed companies will be Rs 660000, 432000, 165000, 88400 and 62500 respectively.
• The market weighted index after 1 year will be (660000 + 432000 + 165000 + 88400 + 62500)/ 5 = 281580; which is an increase of nearly 10% compared to last year index value of 256200.
• Let’s consider after another 1 more year the prices become USD 370, 220, 115, 60, and 30 respectively.
• So after another 1 year the market caps of all these 5 listed companies will be Rs 740000, 396000, 172500, 102000 and 75000 respectively.
•  At the second time the market weighted index will be = (740000 + 396000 + 172500 + 102000 + 75000)/5 = 297100; which is an increase of nearly 5.5% in last one year.

As the bonus issue and stock split cases do not affect the market capitalization, the base value is not needed to be revised for any such cases.

The major disadvantage of the market weighted index is that the stocks with larger market capitalization have greater impact on the index than the stocks with smaller market capitalization.

Free Float methodology

This is a special type of market weighted index, where only the tradable shares are considered while calculating the market capitalization of the contributing shares. This consideration of only the tradable shares to calculate the index changes the market weighted index value considerably. Indian Market index Sensex follows the same methodology. Because of this we can see that shares with very high market cap may not have high weight in the index because of lower number of tradable shares.

Let us visit the above example to understand this methodology.

Example

Let us see the below example to understand the basics of price weighted index

• Suppose there are 5 stocks in the index. At the time of creating the index, their prices were USD 300, 220, 100, 50 and 20 and the total numbers of tradable shares are 500, 1100, 700, 1700, and 2000 respectively.
• At the time of base index creation, the market caps of the tradable shares of all these 5 listed companies are 150000, 242000, 70000, 85000 and 40000 respectively.
• The weight of the first company in the overall index is nearly 25.5% which is significantly lower than the weigh calculated based on the whole market cap.
• The average or the market weighted index (based on free float) at the time of creation was (150000 + 242000 + 70000 + 85000 + 40000)/ 5 = 117400
• Suppose after 1 year the share prices become USD 330, 240, 110, 52 and 25 respectively.
• So after 1 year the market caps of tradable shares of all these 5 listed companies will be Rs 165000, 264000, 77000, 88400 and 50000 respectively.
• The market weighted index after 1 year (based on free float) will be (165000 + 264000 + 77000 + 88400 + 50000)/ 5 = 128880; which is an increase of nearly 9.78% compared to last year index value of 117400.
• Let’s consider after another 1 more year the prices become USD 370, 220, 115, 60, and 30 respectively.
• So after another 1 year the market caps of tradable shares of all these 5 listed companies will be Rs 185000, 242000, 80500, 102000 and 60000 respectively.
•  At the second time the market weighted index (based on free float) will be (185000 + 242000 + 80500 + 102000 + 60000)/5 = 133900; which is an increase of nearly 3.89% in last one year.

Here the stocks with larger market capitalization (based on free float) calculated using only the tradable shares will have larger impact on the index value than the smaller market capitalization stocks.

As the bonus issue and stock split cases do not affect the market capitalization, the base value is not needed to be revised for any such cases. But for any cases of new share issue or buyback which changes the number of tradable shares, the base has to be revised.