HOW THE NASDAQ COMPOSITE WORKS
The Nasdaq Composite® Index is a capitalization-weighted index, unlike the Dow Jones Industrial Average, which is a price-weighted index. That means the Composite Index’s value is based on the total market value of all the issues that compose the index.
The Composite is also a ratio, based upon the relationship between the total market value of all the stocks that compose the index today and the total value on the first day the index was issued. To get the index value, you divide the current market value (sum of price times total shares outstanding for each index security) by the market value on day one of the index.
For example, suppose an index is created today. The current market value of all index securities is $10. Divide that number by the market value on day 1, which is also $10, so the index value is 1 ($10/$10).
If the prices of the securities in the index go up so that the market value increases to $11, the value of the index increases to 1.1 ($11/$10). To create a more meaningful number, the ratio derived above is multiplied by a base value. In the case of the composite, that base value was 100.
Combining these two elements—total market value and the ratio—allows the index to be computed by the following: Index value = current market value/base period market value x base value of the index.
When index components, however, change or index companies issue new shares, of course, the current market value changes. But because this change is not the result of price changes in the market, the base period market value (the divisor) must be adjusted to allow for the component or share change in such a way that the index value after the change is the same as it was before.
This means the formula then becomes: Index Value = Current Market Value/Adjusted Base Period Market Value x Base Value of the Index.
In addition, dividend payments by index companies should reduce the company's price and therefore its market value. However, Nasdaq does not "add back the dividends." Indexes which do add back the dividends are referred to as "total return indexes."
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