The S&P 500 measures the value of stocks of the 500 largest corporations by market capitalization listed on the New York Stock Exchange or Nasdaq Composite. Standard & Poor's intention is to have a price that provides a quick look at the stock market and economy. Indeed, the S&P 500 index is the most popular measure used by financial media and professionals, while the mainstream media and general public are more familiar with the Dow Jones Industrial Average.
The S&P 500 index is calculated by taking the sum of the adjusted market capitalization of all S&P 500 stocks and then dividing it with an index divisor, which is a proprietary figure developed by Standard & Poor's. However, most sources peg this number at 8.9 billion. The divisor is adjusted when there are stock splits, special dividends or spinoffs that could affect the value of the index. The divisor ensures that these non-economic factors do not affect the index.
The index is calculated as follows:
Index = SUM (market cap all S&P 500 stocks) / DIVISOR
One result of this methodology is that the index is weighted toward larger-cap companies.
For example, on March 20, 2015, the largest component was Apple at $744 billion. The smallest component was Diamond Offshore Drilling at $3.76 billion. The total market capitalization of all the companies in the index was $18.8 trillion.
The weighted average market capitalization of each individual component is then determined by dividing the market capitalization of the individual component by $18.8 trillion. Apple's weighting is determined by taking its market capitalization of $744 billion and dividing it by $18.8 trillion. For Diamond Offshore Drilling, it is $3.76 billion divided by $18.8 trillion.
The formula for determining this weighting is as follows:
Weighting = Market Cap of Individual Component / SUM (market cap all S&P 500 stocks)
Therefore, using the same example, Apple has a nearly 4% weighting, while the smallest component, Diamond Offshore Drilling, has a 0.2% weighting in the index. This leads to the mega-cap stocks having an outsized impact on the index. Sometimes, this index structure can mask strength or weakness in smaller companies if larger-cap companies are diverging. In other ways, this index structure better represents the overall economy than indexes in which weighting is determined by an equal share or an index that is price weighted.
The S&P 500 is also considered an effective representation for the economy due to its inclusion of 500 companies, which covers all areas of the United States and across all industries. In contrast, the Dow Jones Industrial Average comprises 30 companies, leading to a more narrow reflection. Further, it is price weighted, so the largest weighted components are determined by its stock price rather than some fundamental measure.