What is 'Weighted Average'
Weighted average is a mean calculated by giving values in a data set more influence according to some attribute of the data. It is an average in which each quantity to be averaged is assigned a weight, and these weightings determine the relative importance of each quantity on the average. Weightings are the equivalent of having that many like items with the same value involved in the average.
BREAKING DOWN 'Weighted Average'A weighted average is most often computed with respect to the frequency of the values in a data set. A weighted average can be calculated in different ways, however, if certain values in a data set are given more importance for reasons other than frequency of occurrence.
Calculation of Weighted Average
Investors often compile a position in a stock over several years. Stock prices change daily, so it can be tough to keep track of the cost basis on those shares accumulated over a period of years. If an investor wants to calculate a weighted average of the share price he paid for the shares, he has to multiply the number of shares acquired at each price by that price, add those values and then divide the total value by the total number of shares.
For example, say an investor acquires 100 shares of a company in year 1 at $10 and 50 shares of the same company in year 2 at $40. In order to get the weighted average of the price paid, the investor multiplies 100 shares by $10 for year 1, 50 shares by $40 for year 2, and then adds the results to get a total value of $3,000. The investor divides the total amount paid for the shares, $3,000 in this case, by the total number of shares acquired over both years, 150, to get the weighted average price paid of $20. This average is weighted with respect to the number of shares acquired at each price and not just the absolute price.
Examples of Weighted Average
Weighted average shows up in many areas of finance in addition to the purchase price of shares including portfolio returns, inventory accounting and valuation. When a fund, which holds multiple securities, is up 10% on the year, that 10% represents a weighted average of returns for the fund with respect to the value of each position in the fund. For inventory accounting, the weighted average value of inventory accounts for fluctuations in commodity prices, for example, while LIFO or FIFO methods give more importance to time than value. When evaluating companies to discern whether their shares are correctly priced, investors use the weighted average cost of capital (WACC) to discount a company's cash flows. WACC is weighted based on the market value of debt and equity in a company's capital structure.