What is a “Market Value Weighted Index”?
A Market Value Weighted Index (MVWI) is the most common type of stock market index whereby the participants are weighted according to the size (market cap) of the company. Examples of such an index include the S&P 500, NASDAQ, and FTSE 100. In such an index, the market capitalization of a stock is determined by multiplying the market price of this stock (for example in US$) by the number of outstanding stocks.
Further, in an MVWI, the stock with a larger (smaller) market capitalization will have a greater (smaller) impact on the changes or movements of such an index, even if its absolute price is lower. Therefore the largest companies in S&P 500 (based on market capitalization) will have the greatest influence on this index’s price performance.
In other words, the valuation of a company determines how much influence it has over the performance of an MVWI. Consequently, the performance of an MVWI, such as the S&P 500, is usually driven by the performance of the constituent stocks with the highest market capitalization.
Key Learning Points
- The most common methodology to calculate stock market indices is the Market Value or Capitalization Weighted Index (MVWI)
- In an MVWI, the constituent company that has the highest market capitalization has the greatest weighting and therefore influence on the movements or changes in the index
- While an MVWI has some advantages, it has disadvantages too
Market Value Weighted Index – Formula, Advantages, and Disadvantages
Essentially, an MVWI is based on the size of each individual firm. Therefore, in an MWI, the weight of each constituent company or security (stock) is determined by dividing its market capitalization or value by the total value of all the securities (stocks) in the index.
To calculate a Market Value Weighted Index, we need to undertake the following steps:
Calculate the market capitalization (MC) of each constituent company. The formula for computing the same is:
Market Capitalization of a Company (MC (US$)) = Stock Price * Number of Outstanding Stocks
If, for example, there are 5 constituent companies, then the market capitalization of each company has been calculated using this formula. Thereafter, to calculate the MVWI (XYZ) in US dollar terms, add (sum total) the market capitalization of all the 5 companies i.e.
MVWI (XYZ) = MC (A) + MC (B) + MC (C) + MC (D) + MC (E)
The advantage of using an MWI is that it reflects the way markets can actually behave. Larger companies do typically have a greater influence and impact on the overall market and the economy than smaller companies. Therefore, it is beneficial to give the former a larger weight in an MVWI.
Another benefit of an MVWI is that as a constituent company’s stock price and value change, so does the proportion of that company in the index basket.
However, a disadvantage of an MWI is that it can be momentum driven i.e. the underlying stocks whose prices have risen the most, have a greater weight in the index and vice-versa. Therefore, companies whose stock prices have fallen the most have a lower weight in the index.
Now, this could result in an over-weighting of those constituent stocks of the index whose prices have risen – and may be overvalued. Companies whose stock prices have declined below their intrinsic fair value (and maybe undervalued) may be under-weighted in the index.
Market Value Weighted Index, Example
In the workout with reference to Market Value or Capitalization Weighted Index, we assume that a stock market index (D&B 100) has five constituent companies. From the information given below, the total market value of this stock market index is computed.
What is notable from this workout is that company EYE has a weighting of 48.3% in the index and has the highest market capitalization. Consequently, it will have a greater impact on the movements or changes in the D&B stock market Index, even if its stock price (US$80) is lower than company ABC’s stock price (US$150).