Index Mathematics

a very short course

David M. Blitzer
Managing Director &
Chairman of the Index Committee
Topics

• Index Calculation
• Index Analysis
• Attribution Analysis
• Valuation Measures
Index Calculation
Divisors, IWF’s and all that
 What’s an Index?

• An index is a collection or portfolio of stocks, bonds or other

investments selected to represent a particular segment of a
market.
– The selection defines the investments in the index,
– It includes a rule for weighting the constituents in the index,
– It includes rules for maintenance when constituents change.

• This presentation focuses on stock indices, but similar

approaches apply to bonds, commodities and other financial
instruments.

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 Examples…

• S&P 500 • MSCI EAFE

• Lehman Aggregate
• S&P/TSX 60
• FTSE 100
• S&P/Citigroup Indices
• S&P SmallCap 600
• S&P Commodities Index
• S&P 500 Equal Weight
• S&P Hedge Fund Index But not the Consumer Price Index
or the Index of Leading Economic
Indicators

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 Kinds of Indices

• Indices can be defined by the kinds of investments included

such as stock indices, bond indices, commodity indices, etc.
• Indices can also be defined by the weight schemes used,
including:
– Capitalization weighted (Cap weighted)
– Price Weighted
– Equal Weighted
– Attribute Weighted

• This presentation covers cap weighted stock indices, such as

the S&P 500

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 Divisors and Calculation

• To understand how and when index funds trade, one must

understand how the index is put together.
• The key to index calculation and maintenance is the Divisor.
• S&P’s Cap-weighted indices are calculated with divisors using a
method developed by the Standard Statistics Company, S&P’s
predecessor, when it introduced indices in the 1920’s. This is
sometimes called the Base-aggregative approach.

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 Cap-Weighted Index Defined
Index = (∑ Pj × S j ) / Divisor
j

• In words, multiply each stock’s Price (P) by its Shares (S) to find its
market cap and then divide the sum of market caps by the divisor.
• Why is it done this way?
– “Cap weighted” means that each stock’s weight in the index is its capitalization
compared to the sum of all the stock’s capitalization.
– For the S&P 500, this sum is about $11 trillion. We could quote the index each
day as the total capitalization, say “$10,978,453,672.22.” That would be
cumbersome. Further, if we changed a stock, the index would change.
– Instead the Divisor scales the index to an easier number – e.g. the S&P 500
closed at 1198.22.

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 The FIVE Index
Company Index Price Shares Outstanding Market Cap Weights
Exxon Mobil Corp. 60.55 6,385,358,000 386,633,426,900 26.5%
General Electric 35.47 10,599,190,000 375,953,269,300 25.8%
Microsoft Corp. 24.12 10,880,222,000 262,430,954,640 18.0%
Citigroup Inc. 44.62 5,225,358,000 233,155,473,960 16.0%
Johnson & Johnson 66.85 2,973,666,000 198,789,572,100 13.6%
Total Market Cap 1,456,962,696,900 100.0%
Divisor 11,655,701,575.20
Index 125.00

In this five stock index, the index is the sum of the

market caps divided by the Divisor.

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 Index Shares and
Float Adjustment
• S&P’s US indices are moving to float adjustment.
• This means that when the indices are calculated they only include
shares that are available to investors, shares that are part of the float.
Unavailable shares include blocks owned by executives or directors if
they total more than 10%.
• S&P reviews each company in the index to determine what percentage
of its shares are available to the public. This percentage is called the
“investable weight factor” or IWF.
• This means that the calculation of the index is now a bit different.
• Everything about the Divisor is the same as before.

Index =
∑ P ×S j j × IWF j
Divisor
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 The FIVE Index
Float Adjusted
Index Shares
Company Price Outstanding IWF Market Cap Weights
Exxon Mobil Corp. 60.55 6,385,358,000 1.00 386,633,426,900 26.9%
General Electric 35.47 10,599,190,000 1.00 375,953,269,300 26.1%
Microsoft Corp. 24.12 10,880,222,000 0.93 244,060,787,815 17.0%
Citigroup Inc. 44.62 5,225,358,000 1.00 233,155,473,960 16.2%
Johnson & Johnson 66.85 2,973,666,000 1.00 198,789,572,100 13.8%
Total Market Cap 1,438,592,530,075 100.0%
Divisor 11,508,740,240.60
Index 125.00

We have added IWF’s and recalculated the index to reflect the new
information. Note that the divisor is smaller because we have removed
some market cap and Microsoft’s weight is lower. Other stocks have
higher weights. This is essentially what was done on March 18th.

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 Counting Shares…
• A company’s shares can be counted in different ways and sometimes
have different names. FASB and GAAP define basic and diluted share
counts. The number of shares used in index calculations start with
basic shares.
• However, a company’s shares change often as employee options are
exercised or shares are bought back or other things happen.
• Because applying all these small changes would require almost daily
index and divisor adjustments, S&P only makes immediate adjustments
when a change is over 5%. Otherwise, share counts are updated once
a quarter. This is the “5% rule.”
• “Index Shares” refers to the share count S&P uses in its index
calculations. Index Shares are multiplied by the IWF in calculating the
index.

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 Index Shares and 5%
• “Index Shares” is the share count S&P uses in calculating the index. It
is multiplied by the IWF.
• If an index fund manager wants to track the index exactly he needs to
know this number, exactly. Data on index shares are valuable.
• Once a quarter – on the 3rd Friday of the last month of the quarter when
futures expire – index shares are updated to reflect all those little, less
than 5%, changes that were ignored.
• None of this changes with float adjustment except that now an index
fund manager needs both Index Shares and the IWF for each stock in
the index.

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 Indices Change…
• The stocks in an index change from time to time because of mergers,
acquisitions or bankruptcies and sometimes companies just don’t fit
anymore.
– Polaroid was once a hot growth “Nifty Fifty” company. Eventually it slipped and
was moved to the small cap index. Later it was removed before it filed for
bankruptcy.
– Microsoft is less than 20 years old as a public company – today it is # 3 in the
S&P 500.
– ExxonMobil, #1 recently, used to be two companies. In fact, it is descended from
the Standard Oil Trust and was one company, then several and now one again.
– Some indices change quarterly or annually on schedules; most of S&P’s
investable indices change only when necessary.
• When indices change, the index level should not change – otherwise
market moves would be confused by index maintenance. The Divisor is the
key to maintenance.
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 Adjusting the Divisor
when a Stock Changes
( Pout × S out × IWFout + ∑ Pj × S j × IWF j ) / Dold = Index =
j

Index = ( Pnew × S new × IWFnew + ∑ Pj × S j × IWF j ) / Dnew

j

• In words, calculate the market capitalization of the index before and after the
change. Before the change we know the market cap, the index level and the
divisor. After the change, we know the market cap (with the new stock instead of
the old stock), we know the index level (which will not change) and we can solve
for the new divisor.
• S&P does the calculations after the market closes. The index opens the next day
with the new stocks and the new divisor, but the index level only changes if the
prices of the stocks change.
• That’s why our press releases sometimes say, “After the close on May 1st, XYZ
company will replace ABC company in the S&P 500.”

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 Solving for the New Divisor

Index = [( Pn × S n × IWF n + ∑ Pj × S j × IWF j )] / Divisor

j

• Using the right hand side of the equation from the last slide we
have the definition of the index.
• Solve this for the Divisor to calculate the new divisor.

Divisor = [( Pn × S n × IWF n + ∑ Pj × S j × IWF j )] / Index

j

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 Bank of America Corp
Replaces Citigroup Inc.
Index Shares
Company Price Outstanding IWF Market Cap Weights
Exxon Mobil Corp. 60.55 6,385,358,000 1.00 386,633,426,900 26.9%
General Electric 35.47 10,599,190,000 1.00 375,953,269,300 26.1%
Microsoft Corp. 24.12 10,880,222,000 0.93 244,060,787,815 17.0%
Citigroup Inc. 44.62 5,225,358,000 1.00 233,155,473,960 16.2%
Johnson & Johnson 66.85 2,973,666,000 1.00 198,789,572,100 13.8%
Total Market Cap 1,438,592,530,075 100.0%
Divisor 11,508,740,240.60
Index 125.00

Index Shares
Company Price Outstanding IWF Market Cap Weights
Exxon Mobil Corp. 60.55 6,385,358,000 1.00 386,633,426,900 27.9%
General Electric 35.47 10,599,190,000 1.00 375,953,269,300 27.2%
Microsoft Corp. 24.12 10,880,222,000 0.93 244,060,787,815 17.6%
Bank of America Corp 44.01 4,053,638,000 1.00 178,400,608,380 12.9%
Johnson & Johnson 66.85 2,973,666,000 1.00 198,789,572,100 14.4%
Total Market Cap 1,383,837,664,495 100.0%
Divisor 11,070,701,315.96
Index 125.00
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 The Divisor can also
Adjust for Shares Changes…
( Pk × S k × IWFk + ∑ Pj × S j × IWF j ) / Do = Index
j

Index = [( Pk × ( S k ± s ) × IWFk ) + ∑ Pj × S j )] / Dn
j

• In words, if the shares of stock k change by s, the Divisor is adjusted so

the index level doesn’t change. This way, an index can be adjusted when
companies issue or buy back shares. The same basic approach is used for
stock price adjustments, such as when a company spins off a unit.
• As with stock changes, these are done “after the close.”
• There are many kinds of corporate actions that require divisor adjustments.
• One common action that does not require a divisor adjustment is a stock
split – shares increase and prices decrease in proportion.

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 10% Share Increase in
Johnson & Johnson
Index Shares
Company Price Outstanding IWF Market Cap Weights
Exxon Mobil Corp. 60.55 6,385,358,000 1.00 386,633,426,900 26.5%
General Electric 35.47 10,599,190,000 1.00 375,953,269,300 25.8%
Microsoft Corp. 24.12 10,880,222,000 0.93 244,060,787,815 16.7%
Citigroup Inc. 44.62 5,225,358,000 1.00 233,155,473,960 16.0%
Johnson & Johnson 66.85 3,271,032,600 1.00 218,668,529,310 15.0%
Total Market Cap 1,458,471,487,285 100.0%
Divisor 11,667,771,898.28
Index 125.00

Compared to the slide on page 11, the share count for JNJ rises
10%, the divisor is adjusted, and JNJ’s weight rises also.
The other stocks weights decline slightly.

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 The Divisor - Summary

• By using a Divisor, we create an index with an easy-to-use level.

• Adjustments to the Divisor assure that changes in the index’s
level reflect changes in the market, not adjustments for
corporate actions.
• The index has meaning over long spans of time and we can use
it to measure long-term investment returns over years, decades
and even centuries.

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Index Analysis
Total returns, shares to buy and more
 Total Return
• Some or maybe all of the stocks in an index will pay dividends.
In the S&P 500, about 380 of the stocks pay dividends.
• Dividends make a big difference and ignoring dividends means
ignoring money. Therefore, two kinds of index returns are
calculated:
– Price return -- the gain or loss from changes in the price of stocks in
the index, ignoring dividends, and
– Total Return -- the gain or loss from owning stocks in the index and
re-investing their dividends in the index. Mutual fund returns are
compared to total return indices.

• To track total return, a Total Return Index (TRI) is calculated.

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 Total Return Index
Dt = (∑ Dividend $ / Divisor )
• First the total dollars paid in dividends each day (or week or month)
across the entire index is calculated,
• This is divided by the Divisor to calculate dollars of dividends per index
point (above)
• The result is combined with the price change in the index to calculate
the daily (weekly or monthly) total return and applied to the total return
index (below)

Indext + Dt
TRI t = TRI t −1 × [ ]
Indext −1
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 Total Return
Indext + Dt
TRI t = TRI t −1 × [ ]
Indext −1
• S&P calculates total return based on the Ex-Date. Ex-Date
stands for “excluding dividend date” – the first day when
someone who buys the stock does not receive the dividend. The
Ex-Date is determined by the record date and settlement rules.
• S&P uses the change in the index level between the day before
the ex-date and the ex-date. In the equation, t equals the ex-
date.

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 Calculating Weights
( Pj × S j × IWFj ) ( Pj × S j × IWF j )
Weight j = =
∑ (P × Sj j × IWF j ) TotalMarketCap

• The weight of each stock in the index is the proportion of its

market cap to the total market cap of the index.
• This is a key variable in a lot of index analysis.

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 How Much of Each Stock do
Index Funds Own?
• For the market overall…

Stock j MarketCap = weight j × TotalMarketCap

• For the fund, the amount in stock j is the weight multiplied by the
portfolio’s size:

Stock j PortfolioCap = weight j × Fund Size

• So, the proportion of each stock’s total cap held in the fund is:

weight j × FundFund Size

Fund Owns = =
weight j × TotalMarketCap TotalMarketCap
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 How Much of Each Stock do
Index Funds Own?

• If index funds as a group • Therefore, if S&P adds a $10

own 10% of the S&P 500, billion float-adjusted market
then the funds own 10% of cap stock to the index, the
the float adjusted market cap index funds together will buy
of each stock in the index. up $1 billion of the stock.

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 Build a Portfolio

• To determine how much to buy of each stock to build a

$1,000,000,000 (one billion dollar) fund based on the FIVE
index we can use the weights calculated on slide 11.
• We can check this by calculating what proportion of each stock’s
market cap the FIVE Fund will hold.

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 Building a Fund

Total For
Company Weights Fund Size Each Stock Shares
Exxon Mobil Corp. 26.9% $ 1,000,000,000 $ 268,758,122 4,438,615
General Electric 26.1% $ 1,000,000,000 $ 261,334,090 7,367,750
Microsoft Corp. 17.0% $ 1,000,000,000 $ 169,652,478 7,033,685
Citigroup Inc. 16.2% $ 1,000,000,000 $ 162,071,934 3,632,271
Johnson & Johnson 13.8% $ 1,000,000,000 $ 138,183,376 2,067,066

Multiply the fund size ($1 billion) by the weights to find the
dollars invested in each stock. Divide this by the price of the
stock to find how many shares the fund must buy.

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 Checking the Ownership
in Each Stock
How Much of
Total for Each Stock is
Company Market Cap Weights Fund Size Each Stock Owned
Exxon Mobil Corp. $ 386,633,426,900 26.9% $ 1,000,000,000 $ 268,758,122 0.070%
General Electric $ 375,953,269,300 26.1% $ 1,000,000,000 $ 261,334,090 0.070%
Microsoft Corp. $ 244,060,787,815 17.0% $ 1,000,000,000 $ 169,652,478 0.070%
Citigroup Inc. $ 233,155,473,960 16.2% $ 1,000,000,000 $ 162,071,934 0.070%
Johnson & Johnson $ 198,789,572,100 13.8% $ 1,000,000,000 $ 138,183,376 0.070%
Index MC $ 1,438,592,530,075
Divisor 11,508,740,240.60 Check: $ 1,000,000,000 0.070%
Index 125.00

For each stock, calculate the percentage of its market cap that is
Owned by the FIVE Fund, compare this to the percentage the
Five Fund is of the index market cap. They should match.

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Attribution
Analysis
What makes the index rise or fall?
 Measuring Why the Index Rose

• Prices change, stocks change and the index moves.

What stock drives the index up or down?
• The answer depends on individual stock weights as well as the
price changes.
• A stock’s contribution depends on both its weight and the price
change, as shown on the following slide.

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 Attribution Analysis
Spreadsheet
Index Shares Contri-
Company Price Outstanding IWF Market Cap Weights bution
Exxon Mobil Corp. 60.55 6,385,358,000 1.00 386,633,426,900 26.9% 0.20%
General Electric 35.47 10,599,190,000 1.00 375,953,269,300 26.1% -0.35%
Microsoft Corp. 24.12 10,880,222,000 0.93 244,060,787,815 17.0% -0.79%
Citigroup Inc. 44.62 5,225,358,000 1.00 233,155,473,960 16.2% 0.86%
Johnson & Johnson 66.85 2,973,666,000 1.00 198,789,572,100 13.8% -0.38%
Total Market Cap 1,438,592,530,075 Sum -0.45%
Divisor 11,508,740,241
Index 125.00

Index Shares Price

Company Price Outstanding IWF Market Cap Weights Change
Exxon Mobil Corp. 61 6,385,358,000 1.00 389,506,838,000 27.1% 0.7%
General Electric 35 10,599,190,000 1.00 370,971,650,000 25.8% -1.3%
Microsoft Corp. 23 10,880,222,000 0.93 232,727,948,580 16.2% -4.6%
Citigroup Inc. 47 5,225,358,000 1.00 245,591,826,000 17.1% 5.3%
Johnson & Johnson 65 2,973,666,000 1.00 193,288,290,000 13.4% -2.8%
Total Market Cap 1,432,086,552,580
Divisor 11,508,740,241
Index 124.43 -0.45%
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Valuation
Measures
Is the market over valued?
 EPS

• On Wall Street, corporate profits mean the EPS on the S&P 500.
How is it measured?
• For a company, EPS is earnings (properly defined) divided by
shares outstanding.
• For the index, the Divisor plays the role of shares outstanding.
• When S&P moved to float adjustment we evaluated the impact
of the change in EPS and found only a small shift – less then
some index changes in the recent past.

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 Calculating Index EPS

EPS =
∑ EPS j × Shares j × IWF j
Divisior

• Start with each company’s EPS, multiply by its shares and IWF
to find its earnings, in dollars, for the shares in the index. The
sum of each company’s dollar earnings is then divided by the
divisor to get the index EPS.

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 P/E Ratios
Index Level
Index P / E =
EPS

• One of the most widely used valuation measures is the P/E

ratio. The market’s P/E is the P/E ratio on the S&P 500. What
does that mean?

Index Level Divisor Total Index Market Cap

× = = P/E
EPS Divisor Earnings of all Cos

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 Dividends
• Recently dividends have been an important factor in valuing
stocks. The market’s dividend yield – the dividend yield of the
S&P 500 – is closely watched.
• For dividend yield, the measure used is Indicated Annual
Dividends – covering only ordinary dividends and assuming
any increases are not reversed.

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 Dividend Yield
• Its calculation is similar to the P/E ratio.

Dividends / share =
∑ dividends j × S j × IWF j
Divisor

dividends / share
Yield =
Index level

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 Understanding Indices

• This presentation has barely scratched the surface in exploring

how indices work and what can be done with them.
• S&P’s indices are a key part of many products and services.
The S&P 500 is one of our most valuable brands.
• Clients depend on indices and index data. As a result, clients
can be demanding, fussy and occasionally difficult to deal with.
On top of that, there is often more than one way to use indices
or solve an analytical index problem.
• Hopefully the background here will make it easier to answer
questions about our indices.

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 In Answering Questions…

• S&P Index Analysis and Index Services doesn’t give investment

advice or advise people on how to trade.
• We deal only in public information.
• Critical index announcements are made available to everyone on
an equal basis and are posted on our web site.
• Other data is posted on Index Alert.
• If in doubt about answering a specific inquiry, ask the client to
send an e-mail to Index_Services – it will be referred to the Index
Committee if necessary.

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Thank you
David M. Blitzer
Managing Director &
Chairman of the Index Committee

(212) 438-3907
david_blitzer@standardandpoors.com