What is the Price-Weighted Index?
A price-weighted index is a type of stock market index in which each component of the index is weighted according to its current share price. In price-weighted indices, companies with a high share price have a greater weight than those with a low share price. Therefore, the price movements of the companies with the highest share price will have the largest impact on the value of the index.
Nowadays, price-weighted indices are less common than other indices. Instead, the capitalization-weighted index is the most prevalent form of the market indices. The biggest price-weighted indices are the US Dow Jones Industrial Average (DJIA) and Japan’s Nikkei 225.
The idea of a price-weighted index is often criticized because it considers only the price of each component as the driver of the index value. Therefore, in price-weighted indices, even a small price fluctuation in the higher priced company may significantly affect the value of the index even though the percentage shift of the fluctuation can be relatively small.
How to Calculate the Weights in a Price-Weighted Index
The weight of a component in a price-weighted index is calculated by dividing the price of a security by the sum of prices of all index components. Mathematically, it is expressed in the following way:
Let’s consider the following example. The PWI Index is a price-weighted index that includes the stocks of four companies. The information about the companies included in the index can be found in the table below:
Using the formula above, we can calculate the weight of each index component:
How to Calculate the Value of a Price-Weighted Index
In theory, the value of the price-weighted index can be determined as an arithmetic average by dividing the total sum of the prices of the components in the index by the number of the index components. However, in current conditions, such an approach is not usually encouraged because events such as spinoffs, stock splits, and mergers affect the composition of the index.
In reality, the value of the price-weighted index is calculated by dividing the total sum of the prices of the index components by the divisor. The divisor is an arbitrary value computed by the index and adjusted for various structural changes in the index components.
For example, the Dow Jones Industrial Average, which is the most prominent price-weighted index in the world, calculates its own divisor (Dow divisor) that is used in the calculations of DJIA levels. The Dow divisor changes over time to better suit the existing composition of the index.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: