Stock Market is not only about transactions of stocks and funds. Every investor needs to familiarise themselves with the various notions and facets of this substantial concept of trading.
One of the fundamental aspects is stock market indices, which determine the stock’s performance in the share market. Investors compare the share prices based on these indices to determine which stock would offer maximum profit.
Complex to understand? Let us help you out. Read this article to learn about the market indices and their calculation. Scroll down for more information.
A Brief Overview Of The Market Index
Market Indices comprise the share prices of the stocks enlisted with them. There are two major market exchange units in India – NSE (National Stock Exchange) and BSE (Bombay Stock Exchange).
These units are home to multiple indices, among which three deserve special mention – the BSE Sensex, NIFTY 50 and NIFTY 500 (in NSE). These indices, in turn, have several stocks registered with them. The rise and fall of the stock market share prices result in their evaluation.
How To Calculate Stock Market Index
There are four methodologies used to calculate all market indices. As mentioned earlier, the primary factor that influences their evaluation is the fluctuation of the share prices of the stocks they have listed. Let us delve in more detail into these five methodologies for improved comprehension.
● Free Float Market Capitalisation Method
Free float shares are the percentage of tradable shares in the market, which usually ranges from 0.05 to 1.0. The government, company shareholders, insiders, etc hold the others. Some shares are also locked as employee stock option plans, which are non-tradable shares. Here, the index is calculated based on these free-floating percentages. India’s exchange units, BSE and NSE, use this method. The calculation has three steps (using SENSEX as an example)
- Market Capitalisation = Share Price x Number of Shares
- Free Float MC = Free Float Factor (percentage of tradable shares) x MC
- Sensex = (Total Free Float Market Capitalisation/ Base Market Capitalisation) x Base period index value.
● Modified Capitalisation Weighted
In this method, each component is weighed relative to its market capitalisation. Here, the larger MC value will have a greater influence on the index and vice versa. This is a collective way of calculation. For instance, NIFTY has 50 stocks listed. Hence, you need to find the MC of each of these stocks. The CWI will be the sum of each of the market capitalisations. The formula for determining each of the weights is
Weight = (MC of each company/CWI) x 100%
● Free Market Capitalisation Method
The number of shares held by shareholders, along with investors and other financial institutions, is multiplied by the market price of the share. The result is market capitalisation. A company with a higher MC can waver the index evaluation to a certain extent. Lastly, the sum of all the share’s market capitalisation is calculated to get the exact valuation of the stock market indexes. The formula is
FMC = Number of shares x Market price of each share
● Price Weighted Index
In this methodology, the weightage of each share is determined according to its current share price. Here, the stock price is divided by the sum of all stock prices. The formula is
Weight = P1/(P1+P2+P3+P4+…Pn)
Theoretically, this is the formula. However, while practically determining the weight, the share price is divided by an arbitrary number, which is fixed by the index and adjusted accordingly. One of the best examples is the Dow Jones Industrial Average Index of America, which uses the Dow Divisor for this method. This figure undergoes necessary alterations based on various conditions.
Ending Notes
The four methodologies discussed above cover the evaluation of almost all market indices and help determine their values. To better assess the indices and draft effective investment strategies, check the probable market fluctuations, accurate prices, and more in Motilal Oswal’s Research 360.
