Capitalization-Weighted Index Explained

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Capitalization-Weighted Index

What Is a Capitalization-Weighted Index?

A capitalization-weighted index is a type of market index with individual components, or securities, weighted according to their total market capitalization. Market capitalization uses the total market value of a firm’s outstanding shares. The calculation multiples outstand shares by the current price of a single share. Outstanding shares are those owned by individual shareholders, institutional block holdings, and company insider holdings.

The components with a higher market cap carry a higher weighting percentage in the index. Conversely, the components with smaller market caps have lower weightings in the index. A capitalization-weighted index is also known as a market value-weighted index.

Capitalization-Weighted Index

Key Takeaways

  • A capitalization-weighted index is a type of market index with individual components that are weighted according to their total market capitalization.
  • The components with a higher market cap carry a higher weighting percentage in the index. Conversely, the components with smaller market caps have lower weightings in the index.
  • Critics of cap-weighted indices might argue that the overweighting toward larger companies give a distorted view of the market.

Understanding Capitalization-Weighted Indices

Most stock market indexes are cap-weighted indexes, including the Standard and Poor’s (S&P) 500 Index, the Wilshire 5000 Total Market Index (TMWX) and the Nasdaq Composite Index (IXIC). Market-cap indexes provide investors with access to a wide a variety of companies both large and small.

The capitalization-weighted index uses a stock’s market capitalization to determine how much impact that particular security can have on the overall index results. As mentioned earlier, market capitalization, or market cap, comes from the value of outstanding shares. The investment community uses this figure to determine a company’s size, as opposed to using sales or total asset figures.

As a result, in the makeup or composition of a cap-weighted index, large movements in share value for the largest index companies can significantly impact the value of the overall index. However, since large companies with numerous outstanding shares tend to be more stable revenue producers, they can provide steady growth for the index. On the other hand, small companies tend to have a lower weighting, which can reduce risk if the companies don’t perform well.

Critics of the cap-weighted indices might argue that the overweighting toward the larger companies give a distorted view of the market. However, the largest companies also have the largest shareholder bases, which makes a case for having a higher weighting in the index.

Calculation of a Capitalization-Weighted Index

To find the value of a cap-weighted index, we can multiply each component’s market price by its total outstanding shares to arrive at the total market value. The proportion of the stock’s value to the overall total market value of the index components provides the weighting of the company in the index. For example, consider the following five companies:

  • Company A: 1 million shares outstanding, the current price per share equals $45
  • Company B: 300,000 shares outstanding, the current price per share equals $125
  • Company C: 500,000 shares outstanding, the current price per share equals $60
  • Company D: 1.5 million shares outstanding, the current price per share equals $75
  • Company E: 1.5 million shares outstanding, the current price per share equals $5

The total market value of each company would be calculated as:

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  • Company A market value = (1,000,000 x $45) = $45,000,000
  • Company B market value = (300,000 x $125) = $37,500,000
  • Company C market value = (500,000 x $60) = $30,000,000
  • Company D market value = (1,500,000 x $75) = $112,500,000
  • Company E market value = (1,500,000 x $5) = $7,500,000

The entire market value of the index components equals $232.5 million with the following weightings for each company:

  • Company A has a weight of 19.4% ($45,000,000 / $232.5 million)
  • Company B has a weight of 16.1% ($37,500,000 / $232.5 million)
  • Company C has a weight of 12.9% ($30,000,000 / $232.5 million)
  • Company D has a weight of 48.4% ($112,500,000 / $232.5 million)
  • Company E has a weight of 3.2% ($7,500,000 / $232.5 million)

Although companies D and E have equal amounts of shares outstanding at 1,500,000, they represent the highest and lowest weightings in the index, respectively, because of the effects of their prices on their individual market values.

The Downside of Capitalization-Weighted Indexes

Over time, companies can grow to the extent that they make up an excessive amount of the weighting in an index. As a company grows, index designers are obligated to appoint a greater percentage of the company to the index, which can endanger a diversified index by placing too much weight on one individual stock’s performance.

Also, index funds or exchange-traded funds buy additional shares of a stock as its market capitalization increases or as the share price increases. In other words, as the stock price is rising, the funds are purchasing more shares at the higher prices, which can be counterintuitive to the investing mantra of buying low and selling high.

If a company’s stock is overvalued from a fundamental standpoint, the purchasing of the stock as its market-cap and price increases can create a bubble in the stock’s price. As a result, purchasing stocks based on market-cap weightings can lead to a stock market bubble and increase the risk of the bubble bursting sending stock prices into free fall.

Market-cap indexes provide investors with access to a wide a variety of companies both large and small

Large well-established companies have a greater weighting providing steady growth for the index

Small companies tend to have a lower weighting, which can reduce risk if the companies don’t survive

As a stock price rises, a company can have an excessive amount of the weighting in an index

Companies with larger weightings can have a disproportionate impact on the fund’s performance

Fund managers can often add shares of overvalued stocks assigning a larger weighting and create a bubble

Real-World Example

The S&P is a market-cap weighted index containing some of the most well-established companies in the U.S.

  • As of March 22, 2020, Boeing Co. (BA) closed down -2.83% to $362.17 while Microsoft Corp. (MSFT) closed down -2.64% to $117.05 for the day.
  • Boeing had a market cap of $209 billion and a weighting of less than 1% in the S&P on that day.
  • Microsoft Corp. had a market cap of $909 billion and a weighting of over 3% in the S&P.
  • As a result, Boeing’s price decline had a smaller impact on the S&P than Microsoft’s impact even though both stocks declined by nearly the same percentage.
  • In other words, Microsoft dragged the S&P down more so than Boeing for that day because Microsoft had a larger market cap than Boeing.

It’s important to note that the market cap weightings change daily with the companies’ outstanding shares and their prices, which results in varying impacts on the overall Dow’s value.

Capitalization-Weighted Index

In a capitalization-weighted index, each component stock contributes its market value to determine the overall index value and, therefore, stocks with greater market value are given more weight in this type of index.

Calculating the Index Value

The market value of each stock can be calculated by multiplying the stock price with the total number of shares outstanding. The sum of the market value of all the component stocks is then divided by a divisor to obtain the final index value. This divisor is an arbitrary number that is first defined when the index is first published.

Example

A capitalization-weighted index, ABC, is first published comprising the following public companies A, B and C.

Company Stock Price Shares Outstanding Market Cap Weightage
Company A $30 1,000,000 $30,000,000 25%
Company B $60 500,000 $30,000,000 25%
Company C $60 1,000,000 $60,000,000 50%

As can be seen from the table above, although company B’s stock price is two times that of company A’s, their weightage in a capitalization-weighted index are the same as their market values are equal.

The total value of the index is: 30m + 30m + 60m = 150m. A divisor of 150,000 is selected to start the index off with an even number of 1000.

Initial Index Value = 150m / 150k = 1000

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S&P 500 Index – Standard & Poor’s 500 Index

What Is the S&P 500 Index?

The S&P 500 or Standard & Poor’s 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. The index is widely regarded as the best gauge of large-cap U.S. equities. Other common U.S. stock market benchmarks include the Dow Jones Industrial Average or Dow 30 and the Russell 2000 Index, which represents the small-cap index.

Standard And Poor’s 500 Index

Weighting Formula and Calculation for the S&P 500

The S&P 500 uses a market capitalization weighting method, giving a higher percentage allocation to companies with the largest market capitalizations. 

Determination of the weighting of each component of the S&P 500 begins with summing the total market cap for the index.

  1. Calculate the total market cap for the index by adding all the market caps of the individual companies.
  2. The weighting of each company in the index is calculated by taking the company’s market capitalization and dividing it by the total market cap of the index.
  3. For review, the market capitalization of a company is calculated by taking the current stock price and multiplying it by the company’s outstanding shares.
  4. Fortunately, the total market cap for the S&P as well as the market caps of individual companies is published frequently on financial websites saving investors the need to calculate them.

Key Takeaways

  • The S&P 500 Index or the Standard & Poor’s 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
  • The S&P is a float-weighted index, meaning company market capitalizations are adjusted by the number of shares available for public trading.
  • The index is widely regarded as the best gauge of large-cap U.S. equities. As a result, there are many funds designed to track the performance of the S&P.

S&P 500 Index Construction

The market capitalization of a company is calculated by taking the current stock price and multiplying it by the outstanding shares. The S&P only uses free-floating shares, meaning the shares that the public can trade. The S&P adjusts each company’s market cap to compensate for new share issues or company mergers. The value of the index is calculated by totaling the adjusted market caps of each company and dividing the result by a divisor. Unfortunately, the divisor is proprietary information of the S&P and is not released to the public.

However, we can calculate a company’s weighting in the index, which can provide investors with valuable information. If a stock rises or falls, we can get a sense as to whether it might have an impact on the overall index. For example, a company with a 10% weighting will have a greater impact on the value of the index than a company with a 2% weighting.

The Widely Quoted S&P 500

The S&P 500 is one of the most widely quoted American indexes because it represents the largest publicly traded corporations in the U.S. The S&P 500 focuses on the U.S. market’s large-cap sector and is also a float-weighted index, meaning company market capitalizations are adjusted by the number of shares available for public trading.

S&P 500 vs. DJIA

The S&P 500 is often the institutional investor’s preferred index given its depth and breadth, while the Dow Jones Industrial Average has historically been associated with the retail investor’s gauge of the U.S. stock market. Institutional investors perceive the S&P 500 as more representative of U.S. equity markets because it comprises more stocks across all sectors (500 versus the Dow’s 30 Industrials).

Furthermore, the S&P 500 uses a market capitalization weighting method, giving a higher percentage allocation to companies with the largest market capitalizations, while the DJIA is a price-weighted index that gives companies with higher stock prices a higher index weighting. The market capitalization-weighting structure is more common than the price-weighted method across U.S. indexes.

S&P vs. Russell Indexes

The S&P 500 is a member of a set of indexes created by the Standard & Poor’s company. The Standard & Poor’s set of indexes are like the Russell index family in that both are investable, market-capitalization-weighted (unless stated otherwise, like equal-weighted) indexes.

However, there are two large differences between the construction of the S&P and Russel families of indexes. First, Standard & Poor’s chooses constituent companies via a committee, while Russell indexes use a formula to choose stocks to include. Second, there is no name overlap within S&P style indices (growth versus value), while Russell indexes will include the same company in both the “value” and “growth” style indexes.

Other S&P Indices

The S&P 500 is a member of the S&P Global 1200 family of indices. Other popular indices include the S&P MidCap 400, which represents the mid-cap range of companies and the S&P SmallCap 600, which represents small-cap companies. The S&P 500, S&P MidCap 400 and S&P SmallCap 600 combine to create a U.S. all-capitalization index known as the S&P Composite 1500.

S&P 500 vs. Vanguard 500 Fund

The Vanguard 500 Index Fund seeks to track the price and yield performance of the S&P 500 Index by investing its total net assets in the stocks comprising the index and holding each component with approximately the same weight as the S&P index. In this way, the fund barely deviates from the S&P, which it is designed to mimic.

The S&P 500 is an index, but for those who want to invest in the companies that comprise the S&P, they must invest in a fund that tracks the index such as the Vanguard 500 fund.

Limitations of the S&P 500 Index

One of the limitations to the S&P and other indexes that are market-cap weighted arises when stocks in the index become overvalued meaning they rise higher than their fundamentals warrant. If a stock has a heavy weighting in the index while being overvalued, the stock typically inflates the overall value or price of the index.

A rising market cap of a company isn’t necessarily indicative of a company’s fundamentals, but rather it reflects the stock’s increase in value relative to shares outstanding. As a result, equal-weighted indexes have become increasingly popular whereby each company’s stock price movements have an equal impact on the index.

S&P 500 Market Cap Example

In order to understand how the underlying stocks affect the S&P index, the individual market weights must be calculated, which is done by dividing the market capitalization of each company by the total market capitalization of the index. Below is an example of Apple’s weighting in the index:

  • Apple Inc. (AAPL) reported 4,801,589,000 basic common shares in its fourth quarter 2020 earnings report and had a stock price of $148.26 at that time. 
  • Apple’s market capitalization was $711.9 billion (or 4,801,589,000 * $148.26). The $711.9 billion is used as the numerator in the index calculation.
  • The S&P 500 total market cap was approximately $23 trillion, which is the sum of the market capitalizations for all of the stocks in the index.
  • Apple’s weighting in the index was 3% and is calculated as follows: $711.9 billion/$23 trillion.

Overall, the larger the market weight of a company, the more impact each 1% change in a stock’s price will have on the index.

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