Do you remember looking at Nifty?
The index that keeps changing every second, digits tumbling, sometimes red, sometimes green. Everything seems so fascinating and yet so confusing. What do all those numbers mean? Why do people laugh and frown as the value goes up or down? These are legitimate questions and we will answer them all for you.
Stock market indices are the benchmark of market performance. It is the statistical average of the entire spectrum of companies operating in the market across sectors. The numbers are the measure of the market performance of the constituent companies. These numbers contain very valuable information that may be worth millions if you know how to interpret it.
There are hundreds of market indices across countries. Some of the most well-known indices are S&P 500, FTSE 100, CAC 40, etc. India has two major market indices namely S&P BSE Sensex and S&P CNX Nifty.
The Sensex represents 30 of the most well-established and financially sound companies in the stock market and is a weighted index i.e the contribution of all the different companies in the index is not equal but proportionate to their size.
The Nifty 50 index is a tad more comprehensive than Sensex as it includes 50 top companies spreading across all the sectors in the market and therefore, is a better representative of the market performance as it covers the entire cross-section of the Stock market. Nifty is also a weighted index just like Sensex.
Understanding and interpreting the values of these indices will add a new dimension to your investing journey. It will help you understand the market in greater depth.
And the best way to learn about these indices is to understand how stock market indices are calculated. The method reveals the entire structure of the index and its movement. It reveals the significance of the digits that never seem to stop.
Direct and Indirect Method to calculate Stock Market Indices
There are two ways in which an index can be calculated. The first one is the Direct Method that is a simple method to calculate an unweighted average. The second method is known as the Indirect method and it is a slightly complex method to calculate the weighted average of the stocks.
Consider a Stock Index containing 20 individual stocks. The prices could be added together ( Price#1+ Price#2+ Price#3+ Price #4……..+ Price#20) and then divided by the total number of stocks to obtain the simple unweighted average of the constituent stocks. The figure hence obtained represents the value of the Index.
Let us consider a similar index again consisting of 20 individual stocks. The initial steps are the same as the direct method. The simple unweighted average of the underlying stocks is calculated. The result is then multiplied by the average trading volume of each of the underlying individual stocks. The result for each stock is then added together to obtain the trading turnover weighted price of the stock index. In this instance, the average is weighted by average trading turnover.
The direct method to calculate the indices is primitive and hence, rarely used in the index calculation. Most of the indices around the world are calculated using the indirect method as it is more accurate and represents the weight of individual stocks in the index price.
How the Stock Market Index S&P CNX Nifty is Calculated With Example
The S&P CNX Nifty consists of the top 50 companies of the Indian stock market. These 50 companies measure across the entirety of the market as they are proportionately spread across all sectors. These companies are known as the Nifty-50.
Nifty is considered to be a more comprehensive measure of performance for the cluster of companies as it involves data from 50 companies as opposed to Sensex that only involves data from 30 companies.
Now to understand how stock market indices like Nifty are calculated we need to consider a rather primitive index because the method of calculation is complex and performing the calculations for all the 50 companies is a tedious task. But we can easily understand the essence of the calculation by doing it for a primitive index. This will help us extract all the valuable insights we are looking for.
So just for the sake of making the process of understanding easier, let us consider a primitive index called Nexus that consists of 5 companies. (A,B,C,D,E). We will be using tables to effectively explain the entire process. But before that, you need to understand a few terms.
Market Capitalization represents the entire value of a company or an organization. It is calculated by multiplying the price of one share by the total number of shares issued by the company.
A company with a share price of Rs. 200 and that has 2,000 shares, has a market capitalization of Rs 4,00,000.
And no we do not mean weight as in Kilograms. Weight here represents the weightage of any particular company in the entire index. The weight of a company in any index is calculated by dividing its market capitalization by the market capitalization of the index.
(Market capitalization of an index is the sum of the market capitalization of all its constituent companies).
Floating shares of a company simply represent the total number of shares available for trading in the stock market. All the shares that are issued by the company are not directly available for trading. Some of them are held by the promoters of the company, some others are pledged.
So the floating shares represent the number of free shares of the company and when the number of floating shares is multiplied by the share price, we get the floating market capitalization of the company.
Ok so now you are all set to understand how to calculate Stock market indices. So let’s begin.
Steps Involved in Calculating indices like Nifty
1- Determine the stock price and the number of floating shares for each stock.
2- Calculate the floating market capitalization of each constituent stock by multiplying the share price by the total number of floating shares.
3- Add all the individual market caps to get the index market cap.
4- Calculate the weight of every stock in the index by dividing its floating market cap by the market cap of the index.
Let’s look at the table to understand the process a little better.
|Company||Share Price ( in Rs.)||Number Of Shares
|Floating Market Capitalization||Weight|
|Total = 16,89,500|
The total market cap for the index is Rs. 16,89,500.
One final operation is performed to calculate the value of the index. We then multiply the weight by the value of the index in its base year. But since, we have a hypothetical index so we will use the base value of Nifty.
The initial value of nifty in 1995-1996 was 1,000 so we will also consider the base value of our index to be 1,000.
After multiplying the weight with the base value, we add all the individual values to obtain the price of the index. It’s the final step in calculating the value of any stock market index.
As explained in the table below-
|Company||Share Price||Number of Shares
|Floating Market Cap||Weight||Weight X Base value
|Total = 16,89,500||Total = 1,000|
So the price of the index comes out to be Rs. 1000, or the value of the index is 1,000 basic points. But the value of the index will change consistently with time due to the changing market cap of the companies. The market cap of the companies can change due to factors like share price movements, shares issue, share split, promoter activity, etc.
And let’s suppose due to the price movements of the shares of these 5 companies and the change in the number of floating shares, the market cap of the index grows to Rs. 30,00,000.
So to calculate the new value of the index we use the following formulae-
Index value = (New market cap/ initial market cap) X base value.
By using this formula, the value of the index is-
Index price = (30,00,000 / 16,89,500) X 1000
So the new index price is Rs 1775.67 or the value of the index has now grown to 1775 basic points.
This is how to calculate stock market indices.
You can learn even more about the stock market in general by reading some good books. Read our article on Top 10 books on the stock market to explore the best books available.
Significance of Stock Market Indices
The change in the value of the index represents the change in the floating market capitalization of the companies in the index. If the value of the index increases, it signifies that the net market cap of all the companies put together is increasing. And that’s a positive sign and signals growth in the economy.
And when the price of the index declines, it shows that the total market cap of the index has declined. It means that the individual market caps of the companies have decreased. This signals contraction of the economy.
That’s what these mysterious numbers on the index chart mean. They can be directly used to identify the growth of the economy, the current sentiment in the market, the current trend in the market and so much more.
We hope that you now understand the indices a little better than you did before reading this article on How Stock Market Indices like Nifty are Calculated and How To Use them?