What is a “Capitalization Weighted Index”?
The most common form of stock market index is the capitalization-weighted index, also known as a market-weighted index. The S&P 500 is an example. In such an index, the weighting of a particular stock is determined by its total market capitalization (calculated by multiplying the market price by the number of outstanding shares). As the stock price changes so does the stock’s market weighted contribution to the index.
In such an index, stocks with a larger market cap have a higher weighting and any movements in their share prices will have a larger impact on the index performance. Consequently, the performance of the S&P 500 is driven mostly by the performance of the stocks with the highest market capitalization.
Alternatives to capitalization-weighted include price-weighted, equal-weighted, or fundamental weighted. The Dow Jones Industrial Average is a prime example of a price-weighted index as the larger share prices (in $ terms) are given a larger weighting in the index. Capitalization weighted is popular as it can reflect the market performance in a stable and reliable way, with the larger companies retaining a greater impact on performance.
Key Learning Points
- The components of a capitalization-weighted index are measured using stocks’ market capitalization, so the larger a company’s market cap, the larger its contribution to an index
- A market capitalization is calculated by multiplying the stock price by the total number of shares outstanding
- Stocks with larger market capitalization can have a bigger impact on index performance due to their greater weighting
- Companies with smaller market capitalizations have less impact on index performance as they make up a smaller percentage of the index
- A downside of this methodology is that the index does not capture outperformance from small capitalization stocks, so investors should seek an equal-weighted or alternative index if they wanted exposure to small cap performance
- There are other factors to consider as part of the capitalization weighted methodology such as liquidity, size of public float, profitability, and is the company’s HQ
Company Valuation Impact on Index
A stock with a larger market capitalization will have a greater impact on the changes or movements of such an index even if its price is lower (please refer to the workout) i.e. the largest companies in NASDAQ (based on market capitalization) will have the greatest influence on this index’s price performance. The four largest companies in the S&P 500 currently make up nearly 10% of the index.
In other words, the valuation of a company determines how much influence it has over the performance of S&P 500. Though the actual construction of the S&P 500 is far more complex, the following workout will provide an idea about the concept of a market capitalization index. As companies grow they are likely to enter an index whereas companies which have underperformed will drop out of an index.
Other factors are taken into consideration with regards to stocks becoming part of an index such as liquidity, size of public float, profitability and the company’s HQ location. Some indices are free-float weighted as well as market capitalization weighted as this reflects the publicly available stock. This is known as ‘float-weighted’ or ‘float-adjusted’. The S&P 500 is both capitalization weighted and float adjusted.
In the workout, we assume that a stock market index (H&T 500) has five constituent companies. Further, the total market value of this stock market index is computed.
The company A has a weighting of 31.9% in the index and the highest market capitalization (despite the fact that its current stock price is the lowest among the 5 constituent companies) Consequently, it will have a greater impact on the movements or changes in the H&T 500 stock market Index, when compared to other constituent companies of this index.