There are three methods commonly used to calculate stock index; price, equal and value weighting. Also known as the capitalization-weighted index, value-weighted indices are currently the most popular of the three.
Value-weighted index weighs individual securities or components against their total market capitalization. The index uses the stock market capitalization to assess the impact of specific security on the overall company value. Market capitalization is the value of the company’s present shares. On their end, investors use the value-weighted index to determine the size of a company, as opposed to using its sales or total assets.
Value-Weighted Index Calculation
Start by multiplying the value of each price with the total number of stocks on the market. The result is the company’s total market value, which is taken as a proportion of the overall total market value. The latter is a sum of the total market values of individual companies in a particular industry.
For example, Company A has 300,000 shares, each worth $125 has a total market value of $37,500,000. Companies B, C, D and E have a calculated total market value or $45,000,000, $30,000,000, $112,500,000 and $7,500,000 respectively.
In such a scenario, the entire market value of the individual components is $232.5, with the value-weighted index for Company A being estimated to be 16.1%.
Value-weighted indices are adjusted in certain instances. For example, when a company issues new shares, its total market worth increases, so does its weighted index. As a result, a majority of value-weighted indexes are reviewed regularly.
The primary advantage of value-weighted indices is that their market worth represents companies. That is an excellent indicator of a company’s position in the economy and the stock market.
Small companies tend to have lower market values hence lesser weighting. This reduces the risk of investors should the business fail to perform or survive.
On the other hand, huge and well-established companies, such as those in the financial or energy industry, typically have greater market values and weighting. Such companies dominate the index, attracting more investors hence have a perfect opportunity for steady growth.
On the downside is diversification is limited, and individual stocks experience too much pressure to perform better. That can hurt the company’s fund’s performance.
Suppose a company’s stock is overvalued for some reason, whether intentionally or unintentionally, the increased purchase of stock can create a bubble. Unfortunately, as more people purchase based on the current stock market bubble, there is an increased risk of bursting the bubble resulting in free fall of the stock prices.
The value-weighted index is crucial in any market or industry. Company owners can know where they stand in the economy as well as the stock. This way, they can find ways to do better and attract investors.
On the other hand, the value-weighted index helps individuals determine when to buy or sell their stocks in a particular company. The downside is that sometimes these indexes can be misleading, causing losses to both parties.