An index divisor is a mathematical factor that allows stock market indexes to accurately show changes in the value of the stock market over time. The divisor of an index does not directly affect investors except that the divisor keeps all of the investment products -- such as exchange-traded funds -- tracking a specific index consistent with the changes in stock market values.
Establishing an Index
A company setting up a new stock market index uses a divisor in the initial formation of the index to set up the start value for the index. After the components of an index are chosen and the values totaled together, the result will be a meaningless and possibly very large number. Consider a simple example: You are putting together a 10-stock index and the total of the share prices is 857. You want the index to have an initial value of 100 so you apply a divisor of 8.57, bringing the initial value of your new index to 100. After the launch, as the share prices of your index stocks change, the divisor will be applied to the new totals, showing index changes from the initial 100 level.
Types of Stock Indexes
Most stock indexes can be classified as one of two types. A price-weighted index totals the share prices of the component stocks in the index and then applies the divisor. The Dow Jones Industrial Average is a price-weighted index. A market-cap-weighted index totals the market value -- share price times shares outstanding -- of the stocks in the index. The value of the components of a market-cap-weighted index can be very large. At the time of publication, the value of the stocks tracked by the S&P 500 was $12.7 trillion. The divisor used to calculate the S&P 500 brings that very large number down to the current value of around 1400.
Changing Index Components
The divisor for a stock index will change when the index drops and adds component stocks. The new stocks will have different values than those replaced, so the divisor is adjusted to keep the stock index from changing due to these changes that are not due to stock market price action. The companies that manage stock indexes regularly review the index components and component changes are made on a regular basis. If a component stock is bought or merged into another company, that stock must be replaced in the index.
Actions by the component stocks and companies affect the divisor of an index. A stock split or stock dividend by a component company requires the adjustment of the divisor of a price-weighted index. These actions do not affect the value of a stock in a market-cap-weighted index. The issuance of additional stock by a company is a corporate action that affects the value and divisor of a market-cap-weighted index. Each time one of these corporate actions is initiated by a component company, the divisor will be adjusted to keep the index relevant to stock market values.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.