Methods of computing stock indices

A stock index, or stock market index, is an index that measures a stock market, or a subset of the stock market, that helps investors compare current price levels with past prices to calculate market performance. It is computed from the prices of selected stocks (typically a weighted arithmetic mean).

An index is a statistical measure that represents the value of a batch of stocks. Investors use this measure like a barometer to track the overall progress of the market (or a segment of it).

There are various methods for calculating the stock market index. In this post, we will discuss some of the major methods to calculate stock market index

1. Full Market Capitalization method

In this method, to determine the scrips weighted in the index, the number of shares outstanding is multiplied by the market price of companies shares. The share with the highest market capitalization would have a higher weighted in the index and would be most influential in the index.  In the end, Market capitalization of all companies will be added and it will be the final value of that index.

The number of shares outstanding means the total number of shares currently held by all its shareholders, including shares held by institutional investors and restricted shares owned by the company’s officers and insiders. S&P 500 index in the USA uses this method.

Full Market Capitalization = No. of shares outstanding * Market Price of one share

2. Free Float Market Capitalization method

Free Float is the percentage of shares available in the market for trading. It excludes restricted shares held by the government in the form of strategic investment, shares held by companies officers and insiders, shares locked under employee stock option plan etc. Companies in the index are provided with the free float factors based on its percentage of shares in free float. Free float ranges from 0.05 to 1.0 Value of index through this method is calculated using following steps-

• Free float market Capitalization using the formula = Total number of free float shares * Market price of each share * Free float factor
• Add Market capitalization of all the companies in the index calculated through step 1.
• Calculate the index value with the help of following formula.

Index Value = (Current Free Float Market Capitalization of index / Base Free Float Market Capitalization of index) * Base Index Value

Free float market capitalization method is used by both BSE and NSE

3. Modified Capitalization Weighted

This method seeks to reduce the effect of largest stock in the index which would otherwise dominate the value of the index. This method sets a limit on percentage weight of the largest stock in the group of stocks. NASDAQ 100 uses this method.

4. Price weighted Index

In price-weighted index calculation method,   each stock influences the index in proportion to its price per share. The value of the index is calculated by adding the prices of each stock in the index and dividing them by the total number of stocks. Stocks with a higher price are given more weight which has a greater influence on the performance of the index. Dow Johns Industrial Average uses this method.

5. Equal Weighing

In this method, percentage weight of every stock in the index is equal. so, all the stocks have equal influence on the index value. Kansas City Board of Trade (KCBT) uses this method.