What is a Price-Weighted Index?
A price-weighted index is an index in which the member companies are weighted in proportion to their price per share, rather than by number of shares outstanding, market capitalization or other factors. The Dow Jones Industrial Average (DJIA) is a price-weighted index.
How Does a Price-Weighted Index Work?
For example, let's assume that the following companies are in the XYZ price-weighted index:
A price-weighted index is simply the sum of the members' stock prices divided by the number of members. Thus, in our example, the XYZ index is: $5 + $7 + $10 + $20 + $1 = $43 / 5 = 8.6.
Why Does a Price-Weighted Index Matter?
In a price-weighted index, stocks with higher prices receive a greater weight in the index, regardless of the issuing company's actual size or the number of shares outstanding. Accordingly, if one of the higher-priced stocks (Company D, in our example) has a huge price increase, the index is more likely to increase even if the other stocks in the index decline in value at the same time.
The Dow Jones Industrial Average is probably the best-known and most widely followed index in the world. At its inception, the DJIA started with just 12 stocks and was priced at 40.94, a far cry from today's levels. The Dow now consists of just 30 stocks, making it one of the least diversified indexes around. The calculation behind the actual Dow value is quite complex, but essentially it is derived by summing up the prices of all 30 member stocks and then dividing that figure by a 'magic number' (also referred to as the divisor).
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An index might establish an arbitrary divisor in order to start the index off with an even number (100 or 1,000, for example). In an effort to maintain the DJIA's continuity, the divisor changes over time to reflect changes in the Dow's 30 component stocks.