How are stock market indices calculated?
To better understand how indices are calculated, it is important to understand how they are constructed.
Each exchange requires their listed companies to maintain a high standard of accounting and public reporting. Companies such as Standard &Poors (S&P), Xetra, Financial Times Stock Exchange Group (FTSE), and others review these published reports to audit the health and growth of publicly traded companies.Once compiled, these companies publish their findings, which global investors have relied on for decades. The S&P 500, Xetra’s DAX 40, and the FTSE 100 have reliably guided investors through both prosperous and challenging times, providing honest insight into some of the world’s largest companies.
How an index is constructed
When compiling an index (group) of companies, it is important to measure them in a way that is useful for investors.
For example, in 1984 investors were interested in keeping track of the top 100 companies that are publicly traded on the London stock exchange. Financial Times Stock Exchange (FTSE), a private organization took upon themselves the task of reviewing earnings reports and accounting records of each company that was traded on the London Stock Exchange (LSE).
Their research helped to understand the overall value (market capitalization) of each company on the exchange. They then selected the top 100 companies based on market capitalization and compiled them into a list. Each quarter, members of FTSE convene to review new earnings reports to determine which companies may remain on the top 100 list, which companies will fall off, and which companies will fill the new vacancies.
How an index’s value is calculated
By compiling the total value of the London Stock Exchange’s top 100 companies (FTSE 100), it may be hard to understand this index’s performance over time. There are two popular mathematical tools that are used in order to break down the number from the trillions to the more digestible thousands that we know today.
Float Adjusted Market Capitalization Valuation
If a company initially issues 1,000 shares, this does not necessarily mean that 1,000 shares are available for purchase or trade in an open market. They may decide that 850 shares (85%) can be traded freely on the London Stock Exchange while the remaining 150 shares (15%) areallocated to internal directors. The value of the company, for the sake of the indices, will be calculated based on those 850 open market shares, excluding the non-tradeable 15%. The terms used to describe these shares are ‘Floating Shares’ or ‘Floating Stock’, or ‘Float’ for short.
This can be visualised as:
(All company shares – locked in shares) X Share value = Free Float Value
In 1984, FTSE compiled the FTSE100 and gave it an initial value of 1,000 points. To come to this number they did a simple equation:
Combined Float Adjusted Market Capitalization (Market Cap) of the top 100 LSE companies =1000
The next quarter, they did another calculation (New Market Cap totals/ previous Market Cap totals) x 1000= Q2 FTSE100 point value
Using this method, you can see that as the value of these companies grow, so do the points of the FTSE100.
Note: In order to keep funds as consistent as possible, companies must demonstrate a market cap that is equivalent to position #90 and may fall to position 111 before being removed.
Price Weighted Valuation
Another method is to consider the price of the stock over the market capitalization of the company.
To do this we compile a list of companies in a group, just as we did for the FTSE, except this time we look at the price of each individual stock and nothing else. This is the system used by Charles Dow and Edward Jones when they created the Dow Jones Industrial Average (DJIA) in 1885.
They began by taking the largest 30 companies that are publicly traded in the United States and giving an equal weight to a single share of each of these companies. To calculate this index’s value, they took a divisor and used it to average all of the stocks.
Total value of each individual share added together / divisor (ex. 1000) = Index Value
Note: The divisor value is not disclosed and is changed regularly to avoid excessive volatility.
Although the DJIA and S&P 500 often trend in the same direction, they can not be compared to one another. Some critics of the Price Weight method point out that it does not account for stock splits, issuing of new stocks, or other fluctuations.