A capitalization-weighted index is a stock market measuring tool in which each stock has an affect that is proportionate to its market value. Under this system, stocks that are worth a lot of money and have a lot of shares outstanding affect the index more than stocks of lesser value. Many of the well-known stock indexes around the world are capitalization-weighted indexes.
In a capitalization-weighted index, each stock is weighted based on its market value. Market value is determined by multiplying the price of a stock by the number of shares available. If a company has a stock price of $100 US Dollars (USD) per share and there are 1 million shares of the company's stock outstanding, its market value would be $100 million USD.
Under this system, a company could have a high stock price, but its market value would be relatively low if it has fewer shares outstanding. If a company called has a stock price of $200 USD but has only 5,000 shares outstanding, its market value would be $1 million USD — far less than the $100 million USD of a company that has 1 million shares outstanding at $100 USD per share. The company with a much lower stock price has a significantly higher market value because it has issued more shares.
The overall value of a capitalization-weighted index is determined by combining the market values of the companies in the index and dividing it by a divisor. The divisor can be any number and is determined by the publishers of the index. If the two hypothetical companies previously mentioned are the only companies in the index, their combined market value would be $101 million USD. If the publishers of the index had selected a divisor of 150,000, the overall value of the index would be 673.33.
Companies that have higher market values affect a capitalization-weighted index more than stocks that have lower market values. In the example above, the company that issued 1 million shares would affect the index much more than the other company because its market value is so much higher. For this reason, changes in the price of a stock can have a significant effect on the total value of a capitalization-weighted index.
