What are index divisors? How do they help in analysing the stock market?

Indices are crucial factors in understanding the performance of individual stocks and the entire stock market. Indices are crucial in assessing the status of the economy. Index calculations involve various components like stock prices, market capitalisations, etc.

Today’s article revolves around one such vital component of index calculations called the index divisor. Let’s learn what index divisors are and how they affect the values of stock market indices.

Stock market indices

An index is a value representing a specific sector of stocks or the entire stock market. The index value acts as a benchmark number to represent the sector’s performance. 

NIFTY is the National Stock Exchange’s benchmark index and SENSEX is the Bombay Stock Exchange’s benchmark index. While NIFTY represents the performance of the top 50 stocks on the NSE, SENSEX represents the performance of the top 30 stocks on the BSE.

What is an index divisor?

Calculating an index involves various factors. One of them is the index divisor.

When calculating an index based on the prices of stocks, all the stock prices related to the index are added together to arrive at a value. However, that number is often random and difficult to remember. That is where the index divisor comes in.

The index divisor is a numerical factor set when an index is created. The number is a simple and easy-to-remember number like 10 or 100, by which the original index number is divided. The number hence arrived is easier to remember and reflects the accurate performance of the market.

Though the divisor is created at the beginning of the index, it goes through adjustments when there are critical changes in the market or stocks related to the index. For example, when a company in the index splits its stock, the price per share drops, which affects the index. To neutralise this effect, the index divisor is adjusted so the index value remains stable and reflects genuine market movements.

There is no rule written about the calculation of index divisors. The index divisor formula and calculation depend on the entity forming the index. 

Example of index divisor

Here’s a hypothetical example considering NIFTY. 

The total market capitalisation of 50 stocks in the NIFTY index: 12,504,500

Base year’s index: 50,000

Assuming that the index divisor is 100, the index value will be 12,504,500 * 100 / 50,000 = 25,009

Benefits of an index divisor 

• The index divisor adjusts the index for changes in the structure of its components, to ensure that the index factors in all the genuine changes in the market. Without adjusting the index using the index divisor, the index could be misleading as it does not factor in all market changes.
• Using the index divisor allows for maintaining consistency in calculation methods, which makes comparisons more accurate. Hence, index divisors are critical for investors while analysing trends and the performance of stocks.

Risks of index divisors

• Adjusting the index divisor for every economic event that affects any of the stocks in the index may be complex. Especially when the index has many stocks going through structural changes simultaneously, adjusting the divisor is difficult.
• Index providers do not usually disclose their divisor adjustments and calculations publicly. Hence, understanding how the index number is calculated becomes complicated.

Significance of index divisors

• Understanding the calculation and uses of index divisors enhances the accuracy of financial reporting and market analysis. It provides data that is more reliable, hence supporting well-informed investment decisions.
• The knowledge of index divisors plays a crucial role in financial organisations, like mutual fund firms, to devise new and innovative products, such as index funds and exchange-traded funds (ETFs), that imitate the performance of indexes.
• It also helps retail investors understand the dynamics of indexes and how they are calculated.

Conclusion

The index divisor, which seems like a trivial part of index calculations, has a significant impact on financial markets. It ensures that indices accurately reflect the effect of economic events and do not get carried away by changes due to corporate actions. 

For investors, though the value of the indexes is readily available, understanding the different components and the calculation methodology of such indexes is essential. Index divisors are essential for investors to make accurate analyses of stocks that help them with their investment decisions.

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