The term capitalization weight refers to a specific approach used in the calculation of a market index. With a capitalization weight index, the total market value of the security determines its influence on the index.
Also referred to as a stock market index, an equity index is a sample of equities, or common stocks, which are used as a benchmark when comparing the performance of a smaller set of equities or an individual stock. The method used to determine how an index is calculated is important for the investor-analyst to understand, since it provides insights into the significance of the index’s movement over time.
If an index is calculated using capitalization weight (also known as cap weight), the total market value of the security determines that security’s influence, or effect on, the movement of the index. The common stock price movement of a larger company, in terms of total market capitalization, will cause the index to move to a greater extent than the same price movement of a smaller company. The total market capitalization of a company is a frequently published value and it’s found by multiplying the total number of shares of common stock issued by the current market price of a share of stock.
The S&P 500 Index is an example of a capitalization weighted index. Because the cap weight approach uses total market capitalization, it tends to overweigh overvalued stocks and underweight undervalued stocks. Proponents of the approach argue larger companies have a greater effect on the economy, so they should have a greater representation in an index that measures the overall state of a market.
Company ABC’s total market capitalization is $100 billion; while Company XYZ’s total market capitalization is $50 billion. Since the total market capitalization of Company ABC is twice that of Company XYZ, a 1.0% change in the price of Company ABC’s common stock will have twice the effect of a 1.0% change in the price of Company XYZ’s common stock.