What’s a stock index number and how to compute it
One of the shortcomings of a price-weighted index is that the relative importance of a company depends on its market price and not on its market capitalisation. Thus, a 20% change in a R200 stock will have a significantly less impact on the index than a similar percentage change in a R1,200 stock, although the first company may have a higher market capitalisation.
Finance theory postulates that the importance attached to a company should be based on its market capitalisation, which is the product of its share price and the number of shares outstanding, and this is the approach taken by the second category of stock indices termed as value-weighted indices.
In the case of such indices, the aggregate market capitalisation on the day of computation is divided by the aggregate market capitalisation on the base date, and the ratio is multiplied by the base date index value, which is an arbitrary number. Any changes to any of the constituent companies is captured by either modifying the divisor, which in the case of such indices is always assigned a value of 1.0 on the base date, or by changing the base period market capitalisation subsequently.
The beauty of such indices is that, in theory,
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