A value-weighted or capitalization-weighted index is a type of stock index that is built based on the market capitalization of each of the securities that make up the index. Sometimes not all the market capital of each security is used, but only the free float.
It is calculated by adding the market capitalization of each of the securities that make up the index, then dividing by the value of the index in a base year, and then multiplying by a certain index number (typically 100).
This type of index is the one that most faithfully represents the reality of the market. Most of the world’s stock indices use this calculation method, such as the S&P 500 and the IBEX 35.
Advantages of capital-weighted ratios
- This type of stock index is considered an objective way of measuring the relative importance of each security that makes up the index, because it measures it by its total value and not the price of each share like weighted price indices.
- They are macro consistent: it is the only type of indices that all investors could invest (Siegel 2003).
- According to the financial asset valuation model (CAPM), it is the only efficient market portfolio for risk assets.
- It requires less rebalancing and adjustment than other indices in terms of splits or stock dividends.
Disadvantages of capital-weighted ratios
- The most important drawback of equity-weighted ratios is that you can be over- influenced by stocks that have a lot of economic value. For example, in 2007 the 5 largest Spanish companies represented 65% of the Ibex 35.
- Another drawback is that these indices, when weighted according to the value of each company, are overweight by the values that are overvalued by the market.
Example of a value-weighted index
Suppose we build a market capitalization-weighted stock index of 3 stocks. The share prices on January 1, 2017 are:
| Share price | No. shares | Market capitalization | |
|---|---|---|---|
| Value A | 10 € | 1000 | € 10,000 |
| Value B | € 30 | 100 | € 3,000 |
| C value | € 80 | 500 | € 40,000 |
| Total | € 53,000 |
If the value of the shares as of January 1, 2018 is as follows:
| Share price | No. shares | Market capitalization | |
|---|---|---|---|
| Value A | € 15 | 1000 | € 15,000 |
| Value B | € 35 | 100 | € 3,500 |
| C value | € 60 | 500 | € 30,000 |
| Total | € 48,500 |
If we count the first table (01/01/2017) as the base year, the value of the index at the time of the second table (1/1/2018) will be:
Value index = 48,500 / 53,000 x 100 = 91.5
As we can see, although stocks A and B have risen, given that the total value of stocks C is twice the other two and has fallen in price, it influences the index more than the other two.