This is part of a series of articles sponsored by NIC Bank. NIC is currently having a Rights Issue that will close on September 14^th. Read more on their rights issue here.

A stock market index is a tool used to track and describe the performance of a stock market over time using numbers or points to express the aggregate value of the entire stock market or particular stocks within that market. By looking at a stock market index, a person can understand the movements of a stock market without having to check the individual stock prices.

For example, the Nairobi Securities Exchange (NSE) 20 Share Index which tracks shares on the Nairobi Securities Exchange is currently at 3,855.14 points from 3,203.35 points in early January meaning that the Kenyan stock market has improved by the 651.79 point difference since then. Stock market indexes are usually generated on a daily basis based on a market day’s performance.

Most stock market indices track select stocks of a certain criteria e.g. stocks of a similar industry or of a certain company size. For example, the NSE 20 Share Index tracks only 20 of the highest market capitalization companies across each industry listed on the Kenyan Stock Market.

How they Work

Stock market indices work by combining the values of the stocks within their scope and then expressing the total value of the stocks against a predetermined base value. The value of the stocks captured within a particular index can be measured in terms of their market price or their market capitalization.

Market capitalization is the total market value of a company’s shares that have been sold to investors in a stock market. For example, if a company has a total of 1,000 shares which are all bought on a stock market for 5 shillings each, that company will have a market capitalization of 5,000 shillings.

Indices which measure the value of stocks using their market price are known as price weighted indices. The value of a price weighted index is gotten by adding all the share prices of the stocks captured within the index and then dividing the total by the number of shares. An example is shown below:

[caption id="attachment_18761" align="aligncenter" width="228"] An example of select shares on a stock market[/caption]

The price weighted index for the five shares above will be calculated as follows:

17+24+13+6+52 = 22.4 points

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By comparing the current value of a stock market index from its agreed upon base value or the index value at a point in the past, a stock market’s performance can be gauged. Stocks with a higher price have a bigger impact on the value of the index and vice-versa. This is the basis for applying price weighted indices to track the stock market.  The Kenyan Stock Market’s NSE 20 Share Index is a price weighted index with a base value of 100 points.

Stock market indices which measure the value of stocks on the basis of the market capitalization of individual company stocks are known as capitalization weighted indices. In much the same way as price weighted indices, capitalization weighted indices such as the NSE All Share Index add all the market capitalizations of the securities (stocks) within them and then divide the total value by the number of individual securities covered within the index.

The Kenyan Stock Market applies the following indices:

• NSE 20 Share Index – It is the oldest Kenyan stock market index established in 1966. As mentioned before, it is a price weighted index that measures the average performance of 20 blue chip counters at the NSE. It is updated once every day after the markets have closed.

• NSE All Share Index – This market index measures the performance of all the shares listed on the NSE by aggregating and then averaging the market capitalizations of all the shares. It has a base value of 100 points as of January 2008.

• FTSE NSE Kenya 15 Index – The FTSE indices were launched in November 2011 to enhance the flow of foreign capital into the NSE.  The index tracks the performance of 15 of the largest stocks on the NSE by market capitalization. It is updated at the end of each trading day.

• FTSE NSE 25 Index – It represents the performance of the 25 most liquid stocks on the NSE. Liquid stocks are the easiest ones to buy and sell on a stock market.