Market-Capitalization Weighting
The market capitalization for a firm is simply the number of shares of its common stock outstanding times the price of the shares. A firm's market capitalization represents the value and importance investors place on the firm. So, __market-capitalization weighted indexes__ are preferred by many index users.
Here is how it works:
| Security | Share price (USD) | # of shares | Market cap (millions of USD) | Market-cap weight |
|----------|-------------|-------------|------------|----------|
| A | 50 | 12,000,000 | 600 | 50% |
| B | 50 | 8,000,000 | 400 | 33% |
| C | 20 | 10,000,000 | 200 | 16% |
| Sum | | | 1,200 | |
To get each company's market-capitalization weight, just divide the individual firm's market cap by the sum of the market caps for the firms in the index. Company A’s market cap weight in the table above is calculated by dividing its market cap (USD 600 million) by the sum of the market cap of the firms in the index (USD 1,200 million) which is 50%. The market-cap weights for the other two firms are calculated the same way.
Using the table above, if the shares of both company A and company B increased by 5%, which do you think would have the biggest impact on the value of the index?
Correct.
The impact on the value of the index would be greater from Company A's share-price increase since it has a greater weight.
Not correct.
The impact on the value of the index will also be impacted by the weight assigned to each security.
Incorrect.
The impact on the value of the index will also include the value of the weights assigned to each company.
Suppose you had given an equal weight in the index to all three companies. That would mean each firm would comprise 1/3 of the index since it has three securities, and each would have a 33% weight.
Compared to an equal weighting, a market-cap weighting will do which of the following regarding prior period price changes.?
Right!
No.
Since market cap = price x number of shares, prior-period price increases will raise the market cap and affect the weighting. Stocks that have had price increases at a higher percentage than the others in the index will have a greater weight.
The primary advantage of market capitalization weighting is that securities are weighted according to their value to the target market. The primary disadvantage is that securities with prices that have risen the most (or least) have a greater (or lesser) weight to the index. These securities may become over- or underweighted.
Suppose you were looking at a company where a large number of shares were not available for purchase. Some companies are closely held, meaning a portion of their outstanding shares is held by controlling interests, such as family members or founders. Those shares are not available to the investing public.
Now suppose you are looking at an index of securities that is weighted by total market capitalization. All of the outstanding shares are reflected in the weighting, but you know that some of the securities in the index have these unavailable shares held by controlling interests. You would like a more accurate weighting that only includes available shares.
How would you adjust a market-capitalization weighted index to account for these unavailable shares?
Correct.
That would be the best way for the weighting to only reflect shares available to the investing public.
No.
If other controlling interests hold shares not available to the investing public, they must also be deducted.
This adjustment is called a __float adjustment__. The market-cap weighting after adjustment only includes those shares available to the investing public. Most of the market capitalization indexes that you see are adjusted this way. This is done by adding a column to the market-cap weighting table that shows the percentage of outstanding shares available to the investing public. This percentage can be flexible and adjusted at a later date if some of the shares should become available.
The table below reflects the adjustment. Notice a second column is added that shows the percentage of available shares. The last column shows the adjusted market cap to be used in the float-adjusted weighting.
| Security | Shares OS | % shares in float | Shares in index | Share price | Float-adjusted market cap (USD) |
|-------|--------|-----------|----------|---------|-----------------|
| Inco | 10,000 | 80 | 8,000 | 125 | 1,000,000 |
| XYZ Corp. | 5,000 | 50 | 2,500 | 75 | 187,500 |
Which company will lose the most weighting because of the float adjustment shown in the table?
No.
Since XYZ only has 50% of its shares available to the investing public, it will lose 50% of its market cap when it is adjusted. Inco has 80% of its shares available, so it will only lose 20% of its market cap.
Yes!
Because XYZ only has 50% of its shares available to the investing public and Inco has 80%, XYZ will lose the most market cap.
To summarize:
[[summary]]
Since only shares available for the investing public to buy are included in the weighting, it best reflects investment opportunities. Some float-adjusted weighting methods also deduct shares owned by governments and other corporations. These shares aren't as frequently traded as those owned by the investing public, so this deduction can reflect the needs of your clients even better.
Company A
Company B
Both have the same share price, so the increases in share price would have equal impact
Place a greater weight on securities whose prices have risen the most in the last 12 months
Prior period price changes will have no effect on market-cap weighting
Reduce the market cap used in the weighting by deducting shares that are unavailable
Reduce the market cap by deducting only those shares held by founders or founding families
Inco
XYZ Corp.
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