This article is an attempt to explain how the NEPSE index is calculated, explain what is market capitalization of a company is, and explain what is total market capitalization of an economy is. In addition, it also explores how NEPSE adjusts the base period’s market capitalization in case of a new listing.
Let’s first understand the concepts of the market capitalization of a company and the total market capitalization of the economy.
What is the Market Capitalization of a Company?
Market capitalization comes in two forms – an individual company’s market capitalization and the total market capitalization of an economy. The total market capitalization of an economy is widely used in the calculation of the NEPSE index.
In simple terms, the market capitalization of a company is the current market value of a company. We get the market capitalization of a company by multiplying the outstanding number of shares of a company by its closing stock price. The number of outstanding shares is sometimes termed as the ‘number of listed shares’. This way, we use the terms ‘number of listed shares’ and ‘number of outstanding shares’ interchangeably.
Market capitalization is an important secondary market indicator as it is compared with the indicator of the economy. Most often, it is used as a leading indicator of the economic situation. In terms of the mathematics, the market capitalization of an individual company is:
$$\text{Market Capitalization of a Company = Number of Outstanding Shares * Closing Stock Price} $$
Total Market Capitalization for NEPSE index
After adding the market capitalization of all companies listed on the stock exchange, we will get the total market capitalization of an economy. In other terms, one can term total market capitalization as the economy’s market capitalization. The total market capitalization is the key concept used in the calculation of the NEPSE index.
How is the NEPSE index calculated?
After knowing the market capitalization and total market capitalization of a company, let’s move on to the actual calculation process of the NEPSE index. We get the NEPSE index by multiplying the ratio of the current period’s total market capitalization to the base period’s total market capitalization by 100. Mathematically, the formula for calculating the NEPSE index can be expressed as:
$$\text{NEPSE Index} = \frac{\text{Total Market Capitalization of Current Period}}{\text{Total Market Capitalization of Base Period}} * 100$$
This method of index calculation is called value weighted method.
Yet there are hundreds of listed companies on the stock exchange, we proceed with the three hypothetical companies – A, B, and C – and generalize the concept to include a comprehensive list of companies.
Now, let’s present the concept with a hypothetical example as follows:
| Company Name | Outstanding Shares | Closing Price | Market Capitalization |
|---|
| Base Period | Current Period | Base Period | Current Period |
| A | 1,000 | 400 | 450 | 400,000 | 450,000 |
| B | 1,200 | 350 | 500 | 420,000 | 600,000 |
| C | 1,500 | 500 | 550 | 750,000 | 825,000 |
| Total Market Capitalization (Total Market Value) | 15,70,000 | 18,75,000 |
From the table presented above, we have:
Total Market Capitalization of Current Period = 18,75,000
Total Market Capitalization of Base Period = 15,70,000
So, placing values in the formula for calculating the NEPSE index, we get:
$$\text{NEPSE Index} = \frac{\text{Total Market Capitalization of Current Period}}{\text{Total Market Capitalization of Base Period}} * 100$$
$$= \frac{\text{18,75,000}}{\text{15,70,000}} * 100$$
$$= 119.43$$
Thus, the NEPSE index for the current period is 119.43 regarding the base period. A similar analogy holds for calculating the NEPSE index while considering the comprehensive list of companies listed on NEPSE.
For a more fundamental concept of how stock price reflects available information, you may read the very famous financial theory – efficient market hypothesis.
Adjustment to Base in Case of New Listing
In reality, the number of the listed companies keeps on changing. Similarly, several outstanding shares also keep on changing as the company issues the right shares, bonus shares, or common shares at the time of capital needs. So, how base period’s adjusted market capitalization is calculated in such a dynamic real world?
The actual practice to adjust the base period’s market capitalization is as follows:
$$\text{Adjusted Base Period’s Market Capitalization} = \frac{\text{New Market Capitalization Including New Listing}}{\text{New Market Capitalization Excluding New Listing}} * \text{Base Period’s Market Capitalization}$$
Hypothetical Example: NEPSE index Base Adjustment
Let’s illustrate the concept of adjustment to base with the following hypothetical example. First, imagine that the initial conditions of the outstanding shares and their prices as under:
| Company Name | Outstanding Shares | Closing Prices | Market Capitalization of Base Period |
|---|
| A | 1,000 | 400 | 400,000 |
| B | 1,200 | 350 | 420,000 |
| C | 1,500 | 500 | 750,000 |
| Total Market Capitalization (Total market value) | 15,70,000 |
Now suppose company ‘A’ offered 25 stock dividends. This corporate action of offering stock dividends has a direct effect on the number of outstanding shares and the stock price of the company ‘A’. The changes in several outstanding shares and stock prices happen as described in this article. For the moment, let’s present the final changes in outstanding shares, prices, and their corresponding market values as under:
| Company Name | Outstanding Shares | Closing Prices | New Market Capitalization |
|---|
| Base Period | Current Period | Current Period | Excluding New Listing | Including New Listing |
| A | 1,000 | 1,250 | 320 | 320,000 | 400,000 |
| B | 1,200 | 1,200 | 500 | 600,000 | 600,000 |
| C | 1500 | 1,500 | 550 | 825,000 | 825,000 |
| Total Market Capitalization (Total Market Value) | 17,45,000 | 18,25,000 |
Following the above table, we have:
New Market Capitalization Including New Listing = 18,25,000
New Market Capitalization Excluding New Listing = 17,45,000
Base Period’s Market Capitalization = 15,70,000
Now, placing the values in the following formula, we get the adjusted base period’s market capitalization:
$$\text{ Adjusted Base Period’s Market Capitalization } = \frac{\text{New Market Capitalization Including New Listing}}{\text{New Market Capitalization Excluding New Listing}} * \text{Base Period’s Market Capitalization}$$
$$\text{Adjusted Base Period’s Market Capitalization} = \frac{\text{18,25,000}}{\text{17,45,000}} * \text{15,70,000}$$
$$ = \text{16,41,977.08}$$
Now the NEPSE Index for the current period is,
$$\text{NEPSE Index} = \frac{\text{Total Market Capitalization of Current Period}}{\text{Total Market Capitalization of Base Period}} * 100$$
$$\text{NEPSE Index} = \frac{\text{18,25,000}}{\text{16,41,977.08}} * 100$$
$$= \text{111.15}$$
This is how the NEPSE index is calculated.
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