What is Weighted Average
A weighted average is an average in which each observation in the data set is assigned or multiplied by a weight before summing to a single average value. In this process, each quantity to be averaged is assigned a weight that determines the relative importance of each quantity. 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. One can calculate a weighted average in different ways. However, 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's 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 or she paid for the shares, he or she must 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 one at $10, and 50 shares of the same company in year two at $40. To get the weighted average of the price paid, the investor multiplies 100 shares by $10 for year one, 50 shares by $40 for year two, 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 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 besides the purchase price of shares, including portfolio returns, inventory accounting and valuation. When a fund, which holds multiple securities, is up 10 percent on the year, that 10 percent 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 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.