Price-Weighted IndexExplained & Defined

Lisa Borga

Date Published: September 15, 2022

A price-weighted stock index refers to a stock market in which the member companies are weighted in proportion to their price per share.

So, if you were to add up the prices of the stocks in the index and then divide this total by the number of companies included in the index, you would determine the value of the index.

Stocks that have a higher price will have more weight in this index and, therefore, will have more influence on the performance of the index than stocks that have a lower price.

Price-Weighted Index Explained

price weighted index

A stock that has its price increase from $240 to $250 will have as much influence on the index as a stock that has its price increase from $50 to $60.

This occurs regardless of the fact that the price of the $50 stock is increasing by a larger percentage than the $240 stock is.

Stocks that have a higher price have much more influence on an index.

The value of a basic price-weighted index can be computed by obtaining the total of the companies share prices and dividing this total by the number of companies.

For some averages, the divisor will be adjusted so as to keep continuity should stock splits or other changes occur to the firms included within the index.

Price-weighted indexes are a valuable tool that allows investors to track the average performance of stock prices for a specific sector of companies or for those in a specific market.

This is due to the fact that the index value will be equivalent to or proportional to the average price of stock values for the firms that are included in the index.

Perhaps the most commonly used example of a price-weighted index is the Dow Jones Industrial Average which includes the stocks of 30 companies in calculating the index.

In the Dow Jones Industrial Average, stocks with higher prices have a greater influence on the index than those with lower prices, which is why the index is considered price-weighted.

The Nikkei 225 is also designated as a price-weighted index.

Additional Weighted Indexes

There are other kinds of weighted indexes in addition to price-weighted indexes, such as unweighted indexes or value-weighted indexes.

Value-Weighted Index

In a value-weighted index, the number of shares outstanding for the stock is considered.

In order to determine the weight each stock is given in this index, you can multiply the price of the stock by the number of outstanding shares.

As an example, if there are 500,000 outstanding shares of Stock X, and the stock is trading at $10, the stock’s weight in the index would be $5 million.

In contrast, Stock Y has 100,000 outstanding shares and is trading at $20.

So, Stock Y has a weight of $2 million.

Therefore, Stock X would have more influence on a value-weighted index than Stock Y.

Unweighted-Index

Stocks in an unweighted index have an equal impact on the index regardless of their share price or volume.

The price changes in this index are based on the percentage of return for each of the components.

As an example, suppose Stock X is up by 15%, and Stock Y is up by 35%, and Stock Z is up by 25%, the index is up by 25%.

This is calculated as follows.

(15 + 35 + 25) / 3  = 25%

Where:

3 = The number of stocks in the index

There are other weighted indexes, such as float-adjusted, revenue-weighted, and fundamentally-weighted, which can be useful in different situations.

It depends on the goals an investor has.

Advantages and Disadvantages of Price-Weighted Index

Advantages of a Price-Weighted Index

  • This type of index makes it easy to evaluate the general health and present state of the economy.
  • The index gives investors an idea of how the market responded to some situations in the past, which can be useful for decision-making.
  • The index is very easy to use as it is simple to calculate and understand.

Disadvantages of a Price-Weighted Index

  • The index can provide an unclear view of the market due to the fact that small companies that have high stock prices will have more influence on the index than large companies with lower stock prices.
  • A particularly large problem with this index is that the stock with the highest price has the largest influence on the index.
  • In these indexes, big and small companies have the same value in the index.
  • When a stock split occurs, the divisor is adjusted, which leads to an arbitrary change in weighting.
  • The index does not always reflect the changes occurring in the market.

Limitations

  • The price-weighted index is actually an average rather than an index. It is a comparison of the presently computed average that uses the same base value.
  • When dividends are issued or a stock split occurs, the divisor needs to be adjusted. If the divisor is not adjusted, the index cannot measure actual growth.
  • The index is biased in favor of stocks with higher prices.

Final Thoughts

Price-weighted indexes are currently not used very often. But, they can be useful for keeping track of the average stock price performance of stocks in a particular market.

However, a price-weighted index is not very useful for tracking changes in the overall market as it does not reflect these changes.

Also, any time a price-weighted index is used, it is important to remember that stocks with higher prices will have a larger impact on the performance of the index.

Key Takeaways

  • A price-weighted index is one in which companies’ stocks are weighted by their share price, and the value of the index is the average of all of the companies share prices.
  • Investors can use a price-weighted index to track the average stock price of a particular industry or market.
  • In a price-weighted index, the divisor will change over time and match the current structure of the index.
  • In a price-weighted index, stocks with a higher price will have more influence on the index.

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