What is the Capitalization-Weighted Index?
The Capitalization-Weighted Index (cap-weighted index, CWI) is a type of stock market index in which each component of the index is weighted relative to its total market capitalization. In a capitalization-weighted index, companies with larger market capitalization exert a greater impact on the index value. Companies with a smaller market capitalization carry less significance.
The capitalization-weighted index is currently the most common stock market index. The largest and most prominent market indices – including S&P 500, the NASDAQ Composite, and the FTSE 100 – are capitalization-weighted indices.
Breaking Down the Capitalization-Weighted Index
Capitalization-weighted indexes are widely used because the values change proportionally to the price changes of each component (since market capitalization is determined by the stock price multiplied by the number of shares outstanding). The indices also consider the shareholder base of each component.
Since some companies own shares that are not fully available to the public, most of the indices use the free float factor to adjust calculations. The free float is the percentage of the shares available for trading.
Some investors criticize capitalization-weighted indexes for providing a distorted view of the stock markets. Many believe that the primary reason for the distortion is the overweighting toward companies with the largest market capitalization.
Example of How to Calculate a Capitalization-Weighted Index
The CWI Composite is a capitalization-weighted index. It consists of four companies only: Company A, Company B, Company C, and Company D. The summary of the current stock prices and the total number of the shares outstanding for each company is given in the table below:
Using the information from the table above, we can calculate the market capitalization of each index component. The market capitalization can be found through the following formula:
Market Capitalization = Stock Price x No. of Shares Outstanding
Thus, the market capitalization of each company in the index is:
- Company A = $5 x 5,000,000 = $25,000,000
- Company B = $10 x 1,000,000 = $10,000,000
- Company C = $25 x 500,000 = $12,500,000
- Company D = $15 x 1,500,000 = $22,500,000
The total market capitalization of the index is the sum of the market capitalization of all the components. Therefore, the market capitalization of the CWI Composite is:
CWI Composite = $25,000,000 + $10,000,000 + $12,500,000 + $22,500,000 = $70,000,000
The weight of each index component is determined using the formula below:
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