SENSEX – the Sensitive Index is also known as the barometer of Indian Capital Markets. This is a kind of barometer that investors base their investments. In this article I am going to talk about SENSEX and how does it work.
As we all know (for those who doesn’t know) Bombay Stock Exchange 30 index which is generally known as SENSEX derives its value based on the movement in prices of 30 blue chip company shares listed in it. Thus SENSEX is just a derivative index which derives its value based on the movement in the prices of securities listed on exchange.
As per Investopedia explanations “SENSEX is the index is calculated based on a free-float capitalization method when weighting the effect of a company on the index. This is a variation of the market capitalization method, but instead of using a company’s outstanding shares it uses its float, or shares that are readily available for trading“.
Now with the above explanation, I am sure the following queries must have been started peeping into your mind;
- What is Free-Float?
- What is Market Capitalization?
- What is Outstanding Shares?
Free-Float: This is just a proportion of shares that are held by investors who are likely to be willing trade. In a simple word it is a measure that of how many shares are reasonably liquid. It therefore does not include restricted stocks, such as those held by company insiders/strategic shareholders that can’t be readily sold.
Market Capitalization: In short, Market Cap or Market Capitalization is the worth of a company in terms of its shares. It represents the aggregate value of a company or stock. Generally it’s obtained by multiplying the number of shares outstanding by their current price per share.
The formula for calculating Market Capitalization is:
Market Capitalization = Market Price of each Share x No of Shares Outstanding
For example, if a company has 2,00,000 shares outstanding and each share price is Rs. 100 then the market capitalization of the company is 2,00,000 x 100 = Rs. 20,00,000
So, when you are talking about “MID-CAP”, “SMALL-CAP” AND “LARGE-CAP” stocks, you are actually talking about the Market Capitalization. Got it..!!!
Outstanding Shares: In short, this is number that is shown on a company’s balance sheet under the heading “Capital Stock”. Outstanding shares include stock held by the investors as well as restricted shares owned by the company’s officers and employees. As stated above, Outstanding Shares is used to calculate market capitalization. This also required in finding out earnings per share
Seems we are diverting from the main topic. 🙂 Let’s come back to the point. How does the SENSEX work & how it’s calculated?
The method for calculating SENSEX is known “Free-Float Market Capitalization”. Under this methodology, the level of index at any point of time reflects the total market value (i.e. market capitalization) of 30 stocks relative to a base period. This market capitalization is further multiplied by the free-float factor to determine the free-float market capitalization.
The base period of SENSEX is 1978-79 and the base value is 100 index points. The calculation of SENSEX involves dividing the Free-Float Market Capitalization of 30 companies in the Index by a number called the Index Divisor. Index Divisor keeps the Index comparable over time and is the adjustment point for all Index adjustments arising out of corporate actions, replacement of scrips, etc.
During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate SENSEX every 15 seconds.
To understand it better, let’s take an example;
Suppose the index i.e. SENSEX has only 2 stocks i.e. ABC Company Ltd. & XYZ Company Ltd. If ABC Company Ltd. has got 10,000 shares in total with a current market price each share is Rs. 35 and out of which 3,000 are held by the promoters, which means only 7,000 are available for trading. These 7,000 shares actually known as “Free-Float” shares (remember..!! its explained above). On the other hand, XYZ Company Ltd. has 15,000 shares at current market price at Rs. 20 each share, out of which 2,000 are held by the promoters and the rest 13,000 are free-float shares.
Here the free-float market capitalization of ABC Company Ltd. will be Rs. 2,45,000 i.e. 7,000 x 35 and the free-float market capitalization of XYZ Company Ltd. will be Rs. 2,60,000 i.e. 13,000 x 20.
With this the total free-float market capitalization of the index will be Rs 5,05,000 (total free-float market cap of Company ABC Ltd. & Company XYZ Ltd.).
The year 1978-79 is considered the base year of the index with a value set to 100. Assume during 1978-79 the market capitalization of the stocks that comprised the index was Rs. 1,00,000 (actual data may be different), Thus the value of the index today will be 5,050 i.e. 5,05,000 x (100/1,00,000). Here 100/1,00,000 is known as Index Divisor as indicated above.
As and when the price of ABC Company Ltd. and XYZ Company Ltd. get change, the value of index also changes. This is similarly applicable to the 30 stocks in SENSEX; the price movement of each stock moves the value of SENSEX as well.
So, this is how the SENSEX is calculated. Hope you will like it.
Remember, unlike the SENSEX, the 50 stocks in NIFTY the index of the National Stock Exchange is based on the market capitalization method and not the free-float method.