Price-Weighted Index Explained

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Price-Weighted Index

What Is a Price-Weighted Index?

A price-weighted index is a stock index in which each company included in the index makes up a fraction of the total index proportional to that company’s share stock price per share. In its simplest form, adding the price of each stock in the index and dividing by the total number of companies determines the index’s value. A stock with a higher price will be given more weight than a stock with a lower price and, therefore, will have a greater influence on the index’s performance.

Key Takeaways

  • In a price-weighted stock index, each company’s stock is weighted by its price per share, and the index is an average of the share prices of all the companies.
  • Price-weighted indexes give greater weight to stocks with higher prices in terms of their contribution to the index value and changes in the index.
  • A price-weighted index can be used to track the average stock price of a given market or industry.

Price-Weighted Index

Understanding a Price-Weighted Index

In a price-weighted index, a stock that increases from $110 to $120 will have a greater effect on the index than a stock that increases from $10 to $20, even though the percentage move is greater than that of the higher-priced stock. Higher-priced stocks exert a greater influence on the index’s, or the basket’s, overall direction.

To calculate the value of a simple price-weighted index, find the sum of the share prices of the individual companies and divide by the number of companies. In some averages, this divisor is adjusted in order to maintain continuity in the event of stock splits or changes to the list of companies included in the index.

Price-weighted indexes are useful because the index value will be equal to (or at least proportionate to) the average stock price for the companies included in the index. This allows the construction of indexes that will track the average stock price performance of a specific sector or market.

One of the most popular price-weighted stocks is the Dow Jones Industrial Average (DIJA), which consists of 30 different stocks, or components. In this index, the higher price stocks move the index more than those with lower prices, thus the price-weighted designation. The Nikkei 225 is another example of a price-weighted index.

Other Weighted Indexes

In addition to price-weighted indexes, other basic types of weighted indexes include value-weighted indexes and unweighted indexes. For a value-weighted index, like those in the MSCI family of strategy indexes, the number of outstanding shares is a factor. To determine the weight of each stock in a value-weighted index, the price of the stock is multiplied by the number of shares outstanding. For example, if Stock A has five million outstanding shares and is trading at $15, then its weight in the index is $750 million. If Stock B is trading at $30, but only has one million outstanding shares, its weight is $30 million. So, in a value-weighted index, Stock A would have more say in how the index moves than Stock B.

In an unweighted index, all stocks have the same impact on the index, no matter their share volume or price. Any price change in the index is based on the return percentage of each component. For example, if Stock A is up 30%, Stock B is up 20%, and Stock C is up 10%, the index is up 20%, or (30 + 20 + 10)/3 (i.e., the number of stocks in the index).

Another type of weighted index is the market capitalization-weighted index, where the shares of each stock are based on the market value of the outstanding shares. Other types of weighted indexes include revenue-weighted, fundamentally-weighted, and float-adjusted. All have their positives and negatives, depending on the investor’s goals and market knowledge.

Price-Weighted Index

What is the Price-Weighted Index?

A price-weighted index is a type of stock market index in which each component of the index is weighted according to its current share price. In price-weighted indices, companies with a high share price have a greater weight than those with a low share price. Therefore, the price movements of companies with the highest share price have the largest impact on the value of the index.

Nowadays, price-weighted indices are less common than other indices. Instead, the capitalization-weighted index is the most prevalent form of market indices. The biggest price-weighted indices are the US Dow Jones Industrial Average (DJIA) Dow Jones Industrial Average (DJIA) The Dow Jones Industrial Average (DJIA), also commonly referred to as “the Dow Jones” or simply “the Dow”, is one of the most popular and widely-recognized stock market indices and Japan’s Nikkei 225 Nikkei Index The Nikkei Index, or Nikkei 225, is the most recognized Japanese stock market index. It comprises Japan’s top 225 companies listed on the Tokyo Exchange. .

A price-weighted index is often criticized because it considers only the price of each component as the driver of the index value. Therefore, even a small price fluctuation in a higher priced company may significantly affect the value of the index.

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How to Calculate the Weights in a Price-Weighted Index

The weight of a individual component is calculated by dividing its price by the sum of all the components’ prices. Mathematically, it is expressed in the following way:

Let’s consider the following example. The PWI Index is a price-weighted index that includes the stocks of four companies. The information about the companies included in the index can be found in the table below:

Using the formula above, we can calculate the weight of each index component:

How to Calculate the Value of a Price-Weighted Index

In theory, the value of the index can be determined as an arithmetic average by dividing the total sum of the prices of the components in the index by the number of the index components. However, such an approach is not usually encouraged because events such as spinoffs, stock splits, and mergers Types of Mergers A merger refers to an agreement in which two companies join together to form one company. In other words, a merger is the combination of two companies into a single legal entity. In this article, we look at different types of mergers that companies can undergo. Types of Mergers There are five different types of affect the composition of the index.

In reality, the value of a price-weighted index is calculated by dividing the total sum of the prices of the index components by the divisor. The divisor is an arbitrary value computed by the index and adjusted for various structural changes in the index components.

For example, the Dow Jones Industrial Average, which is the most prominent price-weighted index, calculates its own divisor (Dow divisor). The Dow divisor changes over time to better match the existing composition of the index.

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How a Price-Weighted Index Works

Assessing the value of a company or security can take a few different forms. You can measure all stocks or securities equally, or use market capitalization. Another choice: a price-weighted index, in which each member company’s stock in an index is weighted proportionally to its current share price.

How to Calculate a Price-Weighted Index

In a price-weighted index (PWI), companies with a high share price are more valuable than companies with a low share price. The higher the share price, the bigger the impact on the index value.

To find the weight of a particular component of an index, divide its price by the sum of all the components in the index, which looks like:

Weight = P1 + P2 + P3 / P1 x 100%

The formula is similar to calculating the percentage of a regular number. Here’s an example:

  • Company 1 share price: $10
  • Company 2 share price: $20
  • Company 3 share price: $30
  • Company 4 share price: $40

To find the weight of Company 1, you would do the following:

$10 + $20 + $30 + $40 / $10 x 100% = 10%

And here’s the breakdown for Company 2:

$10 + $20 + $30 + $40 / $20 x 100% = 20%

$10 + $20 + $30 + $40 / $30 x 100% = 30%

$10 + $20 + $30 + $40 / $40 x 100% = 40%

As you can see from this example, Company 4 has the highest price-weighted index.

The Dow Jones Industrial Average (DJIA) is a type of price-weighted index that currently measures the stock performance of 30 large companies. But this index is calculated a bit differently. Here, you add up the stock prices of the Dow’s 30 components, then divide that sum by the “divisor,” a number that changes regularly depending on what’s happening with the 30 stocks.

Why a Price-Weighted Index Matters

In a PWI, stocks with higher prices have more weight without regard to the company size or other factors, like outstanding shares.

A major feature of a PWI is that larger companies will always have the biggest impact, even if they grow only a little bit. In the example above, Company 4 above has the greatest impact at 40%. If its price rises from $40 to $45, it will still have more impact than if Company 1 went from $10 to $20, because the overall percentage — and not the change itself — is greater. For the DJIA, the higher-priced stock affects the index more than companies with lower prices, even if the change among the lower prices is more significant, percentage-wise.

Along those lines, if the larger company grows slower and smaller companies decline at the same time, the index can still increase.

What Do Other Indexes Look Like?

The PWI is only one type of index. There are other ways to measure indexes, both weighted and unweighted.

Capitalization-Weighted Index

This type of market index weighs individual securities according to their total market capitalization. Market capitalization — or simply, “market cap” — multiplies the total number of outstanding shares a company has by the current market price of one share.

Larger growth for higher market cap companies can significantly impact the overall index. Even steady growth for large index companies can be good as well, especially if lower index companies aren’t as stable. It also means that when share prices of a larger company drops, it has less of an impact on the index than if the same were true for a company with a lower weight — even if their drops are similar in percentage.

To calculate a cap-weighted index, multiply the market price by the total number of outstanding shares. Take the total market value of each company and divide it by the entire market value.

The higher the market cap, the higher the percentage a company weighs in an index. Smaller market caps mean lower weights in the index. The S&P 500 Index and Nasdaq Composite Index are both capitalization-weighted.

Fundamentally Weighted Index

This type of index weighs components on fundamental criteria instead of market capitalization. Metrics can include:

  • Revenue
  • Earnings
  • Book value
  • Dividend rates

These securities are based on a set of fundamental characteristics and are common in customized tracking indexes used by passive management firms. So depending on the fund company you go with, the fundamentally weighted index could be calculated differently.

Unweighted Index

An unweighted index gives equal weight to all securities in an index. These aren’t as common since most indexes come from market capitalizations, which means there’s weight behind those calculations.

The Bottom Line

One type of index isn’t necessarily better than the other; all indexes show different things, depending on how you look at them.

While market capitalization might be a popular measure for indexes, you can look at other measurements too, like a fundamentally weighted index or even an unweighted index. To get a holistic view of how well (or badly) a stock or security is performing, use many different types of indexes to measure it.

How Different Weighted Indexes Play Into ETFs

Many Exchange Traded Funds (ETFs) use indexes as their underlying benchmarks, so it is equally important to understand the different types of indexes. Your ETF investing strategy depends on them. The three main types of indexes are price-weighted, value-weighted, and pure unweighted. 

Price-Weighted Indexes

With a price-weighted index, the index trading price is based on the trading prices of the individual securities (stocks) that comprise the index basket (known as components).

In other words, the stocks with the higher prices will have more impact on the movement of the index than stocks with lower prices, since their price is “weighted” higher. 

If a stock goes from $100 to $110, because its price is higher, it will move the price-weighted index more than a stock that goes from $20 to $30, even though the percentage move is greater for the lower-priced stock.

One of the most popular price-weighted indexes is the Dow Jones Industrial Average (DJIA), which consists of 30 different components. In this index, the higher-priced stocks move the index more than those with lower trading prices, ergo price-weighted. 

Value-Weighted Indexes

In the case of a value-weighted index, the amount of outstanding shares comes into play. To determine the weight of each stock in a value-weighted index, the basic formula (without getting too complex for demonstrative purposes) is to multiply the price of the stock by the number of outstanding shares. 

If Stock ABC has 6 million outstanding shares and trades at $15, then its weight in the value-weighted index is $90 million (15 x 6). But if stock XYZ is trading at $30, and has only 1 million outstanding shares, its weight is $30 million (30 x 1).

So, in a value-weighted index, ABC would have more impact in the movement of the index, but in a price-weighted one, it would have less value since its price is lower. Some examples of value-weighted indexes, sometimes called capitalization-weighted indexes, are the popular MSCI family of strategy indexes.

Unweighted Indexes

The third variation of weighted indexes is the unweighted index, which some call the equal-weighted.   All stocks, regardless of share volumes or price, have an equal impact on the index price. The price change in the index is based on the percentage return of each component.

Say there are three stocks in our unweighted index example: ABC, XYX, and MNO. Regardless of how many shares you have of each stock or the actual trading price, look at the percentage of price movement. So if ABC is up 50% and XYZ is up 10% and MNO is up 15%, the index is up 25% = (50+10+15) / 3 (the number of stocks in the index).

This calculation is based on an arithmetic average, but some unweighted indexes will use a geometric average calculation as well. So then the formula would change to (1.5 + 1.1 + 1.15) [1/3]. Typically, the geometric formula will generate a slightly lower percentage than the arithmetic formula, but still should be relatively close.

Index Summary

While there are other types of weighted indexes—revenue-weighted indexes, fundamentally-weighted indexes, factor- and even float-adjusted indexes—the three outlined here are the ones most typically used with ETFs.

Unlike funds that are chosen by a manager, ETFs are passive with stocks selected automatically to match a particular aspect of the market. Based on the type of fund, different proportions of the underlying stocks are held. Because ETFs are automated, they typically carry lower operating costs.

There are many arguments about which types of weighted indexes are best, but in the end, it depends on your personal situation.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor, and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

Price-Weighted Index

Price-Weighted Index refers to the stock index where the member companies are allocated the on the basis or in the proportion of the price per share of the respective member company prevailing at the particular point of time and helps in keeping the track of the overall health of economy along with its current condition.

What is Price-Weighted Index?

A price-weighted index is a stock market Index in which companies’ stocks are weighted according to their share price. A price-weighted index is mostly influenced by stock which has a higher price and such stock receives greater weight in the index regardless of companies issuing size or number of outstanding Shares. Stock with fewer prices has less influence on the index. In simple words, PWI is an arithmetic average of Prices of securities included in the index.

DJIA (Dow Jones Industrial Average) is one of the Price-Weighted Index in the world.

Price-Weighted Index Formula

Price-weighted index formula is represented as follows,

Price-Weighted Index Calculation Examples

From the below index calculate, what proportion does each stock represent?

So Weight of Netflix in the above index can be calculated as,

= $0.7652

So Weight of Ford in the above index can be calculated as,

= $0.0365

So Weight of Buffalo wild wing in the above index can be calculated as,

= $0.1983

Therefore, the calculation of the price-weighted index will be as follows,

PWI = $95.83

Two Major Price-Weighted Index

  1. Dow Jones Industrial Average – Based on 30 U.S. Stocks
  2. Nikkei Dow – Based on 225 Stocks

Advantages of Price-Weighted Index

  • With the help of Price-Weighted Index, it is easy to track the overall health of the economy and the current condition of the economy.
  • It allows investors to take a decision and with the help of historical data in the index it gives an idea to investors how the market reacted to certain situations in the past.
  • One of the most important advantages of Price-Weighted Index is of its simplicity, it is easy to calculate, understand and the weighing scheme is simple to understand.

Disadvantages of Price-Weighted Index

  • If the price of small firm stock changes has the same effect on index as price changes in large firm stock.
  • A stock price in the index is not a good indicator of its true market value.
  • Small companies with higher share price may have higher weight and larger companies with a low share price will have Smaller weight and which will show an unclear or uncertain picture of the market.
  • One of the most important disadvantages or serious bias of it is that the stock which nominally has higher share price has the greatest impact in the index and due to these most of the stock indices don’t use Price-Weighted Index.
  • One of the disadvantages of it is that even in the event of stock splits adjustment is done with divisor and it leads to arbitrary changes in weights.
  • Due to stock splits price of growing firm reduced which gives downgrade bias to index.
  • An index is just am access to a certain market and it doesn’t mean it is 100 % accurate and there is a number of factors that change the direction of market which that a sometimes do not reflect in an index.
  • In the price-weighted index method small and large companies have the same importance or value in the index price.

Limitations of Price-Weighted Index

  • Whenever there are stock splits or Dividend, divisor should be adjusted otherwise index will not or would not able to measure actual growth. So this means stock splits cause issues.
  • If you look at Price-Weighted Index strictly it’s not an index at all it is an average, the index is nothing but the comparison of currently calculated average with the same base value.
  • Security price or stock price alone can’t communicate its true market value. It ignores market factors of supply and demand
  • The problem with the price-weighted index is that it is biased towards high price stock.

Important Points

  • PWI nowadays less common as compared to other indices and most common and biggest price-weighted indices are Dow Jones industrial average (DJIA) and Nikkei 225
  • This technique considers only the price of each component to arrived at the final value of the index.
  • Spin-off, merger and stock split affect the structure of the Index.
  • An important point to note in a price-weighted index that divisor change over the time to match with the current structure of the index.

Conclusion

Above description gives an insight about how the PWI provides insight into the share price of a stock in the market. An index generally measures a statistical change in the portfolio of stocks which represents the overall market. In the year 1896 first index was created which is known today with name Dow Jones Industrial Average (DJIA). Nowadays it is less popular and used as compared to other indices due to certain limitations to index. There are some advantages and disadvantages associated with the price-weighted index.

It is clear that it reflects changes in stock prices but did not reflect any changes in the market. For successful trading of an index, one should have an understanding of the construction of indexes and if differences and interrelationship among the indexes are understood then it is easy to understand the futures contract that is based on indexes. In price-weighted index stock with higher price has a higher impact over the performance of the index.

This has been a guide to what is Price-Weighted Index. Here we discuss how to calculate Price-Weighted Index using its formula along with practical examples. You may learn more about Investment Banking from the following articles –

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