Chapter 9: Stock Indices and their Calculation

So, now we have touched upon why stock indices are essential.

But you must wonder how you as an investor can use this knowledge to make wise investment decisions?

Importance of stock indices

Well, here's how stock indices help you make informed decisions:

• Sorts from a wide range of stocks

With thousands and thousands of companies listed, how can you differentiate between all? How would you know which is the right one to choose from so many? And that's where a stock market index helps you to classify shares based on vital characteristics such as the size, liquidity, industry or sector and so on.

• Representation of the entire market or a segment

A broad stock market index represents the entire market. In India, the BSE Sensex and the NSE Nifty50 are regarded as broad indices representing overall market performance. Similarly, an index comprising IT stocks or FMCG stocks may represent major companies in the particular industry.

• Easy to compare performance

As an investor, you can use a stock market index to compare performance and use it as a benchmark. It can help you identify market trends quickly without having to compare individual stocks. That’s why some of the popular indices are also known as benchmark indices.

• Reflection of the market sentiments

When you invest in the stock market, you need to keep track of investor sentiment as it is an essential part of stock market movements. That means, if the market sentiment is positive, you may see a demand for stocks, driving up stock prices. Stock market indices reflect investor’s mood/sentiment within sectors, company sizes and the overall market.

• Aids in passive investment

Several investors choose to invest in securities closely resembling an index. This is referred to as passive investment. This means if you invest in an Index Fund or ETF, the fund would mimic the composition and performance of the underlying index. Having an index portfolio can save you the time and effort in researching and selecting stocks.

Free float market capitalization

But let’s say, you want to invest in a large company with a strong management team. This would mean the chances of the company dominating that particular industry in addition to being financially stable is high.

Well, in this case, you can use market capitalization to filter out the large cap companies to invest in. These are the top 100 companies in terms of market capitalization.

Now, how is that calculated?

Here’s how:

Market Cap = Total No. of shares X per share price

But won’t the promoter or let’s say, the higher management of such companies have shares in the company which are not available in the open market to the public?

Yes, it is very likely that they do. Those shares are categorized as promoter’s holdings.

So, would this calculation of the market cap be an accurate representation of the company to the public?

Well, maybe not. And that’s the reason why SEBI introduced Free Float Market Capitalization.

Free Float Market Capitalization only takes into account the shares that are made available to the public. And this method helped remove the companies which have very small equity traded in the market.

It is basically the product of the share price to the total number of shares excluding the promoter’s holdings.

Free Float Market Cap = Per share price X (Total No. of shares – No. of shares available with promoters)

How are stock indices calculated?

Now, you must have heard this in the news –

"Sensex, Nifty close at fresh record highs"

"Sensex closes 226 pts higher."

Now, doesn't this make you wonder how one calculates the value of indices like Sensex and Nifty?

And how does that value represent the companies listed in the respective index?

Well, let’s check it out -

Before we step into the calculation, here’s what you need to know –

• An index value is calculated in real-time.
• Every stock in an index is assigned a specific weightage based on its market capitalization.
• The weightage further represents the extent of impact the price of the stock has on the value of the index.

Now, there are three steps to calculate an index value. Here's how it is done:

Step 1: In the first step, the market capitalization of every company comprising the index is determined by multiplying the price of their stocks with the number of shares issued by the company.

Market Cap = Total No. of shares X per share price

Step 2: The second step involves a free float factor — this means the market value of the holdings that is available for trading in the market.

Let’s say only 55% of the company is available to the public. Then the free float factor of the company would be 0.55.

Here’s how you can calculate the free float market cap with free float factor.

Free Float Market Cap = Total No. of shares X Free float factor X per share price

 Step 3: In the third step, the sum of the free-float market capitalization of all the stocks in the index is divided by a similar sum calculated during the base period. This ratio is then multiplied by the index’s base value — which is typically 100 or 1000. For instance, the base year for Sensex is 1978-79, and the index value was 100.

Let’s simplify this with an example:

Let's assume we need to calculate the index value of the index – ‘NXD 3’ that contains stocks of three companies - Company A, Company B and Company C.

With this example, you now know, the index value of the index ‘NXD 3’ is directly connected to the weightage of underlying companies and the corresponding changes in their market price.

This is how an index represents the performance of the companies listed under them.

Additional Read: Types of Stocks & Investing

Summary

• Understanding a stock market index can make it easy for you to know the stock market’s health without monitoring individual stock movement.
• Market capitalization or market cap helps filter out companies in term of their worth in the open market.
• Market cap is a company's stock price times the number of outstanding shares.

Now that we've covered how stock market indexes help you and how to calculate them for better investment decisions, let's move onto the next chapter where we go in depth into IPOs.