How to Determine the Formula to Calculate the Price Index

by David Ingram

An index presents an average price or value of a given group of similar assets. Indexes are used to analyze overall price shifts in certain products or commodities. The Standard & Poor's 500 Index, for example, presents an average price of 500 hand-picked stocks. The Consumer Price Index (CPI), as another example, measures the average cost of a select group of consumer staples, such as milk, bread and gasoline. Calculating the value of an index is as simple as calculating a mathematical average; the key to calculating a price index is to select the mix of specific assets that will combine to give an accurate reflection of overall price conditions in the asset category being analyzed.

1. Determine how many units you would like to include in the index, or how many units are included in an already-established index. The S&P 500 contains 500 stocks, for example, while the Hang Seng stock index in Hong Kong contains 33 stocks. Think about how wide of a group your index needs to represent when determining the number of units to include. If you are analyzing stock prices of large-cap companies in a specific industry, for example, a smaller list may suffice, whereas a larger list would help if you were analyzing all companies in multiple industries.

2. Select a group of specific units to include in the index, or identify the units already included in the index. The Dow Jones Industrial Average, for example, includes hand-picked, large-cap stocks from the manufacturing sector, including General Electric and Chevron, in addition to other large companies. Spend some time thinking about exactly what information you are trying to gain from your price index when deciding what to include. If you are compiling a price index of real estate for sale in a given area, for example, include a mixture of different types of homes and different locations within the region.

3. Set up a spreadsheet with pre-defined formulas to simplify the process of recalculating index values on a regular basis. Write down the names of all the units you would like to include in the index in a single column near the left of the page. Alphabetize the list to make it easier for you to input the current price values.

4. Research and write down the different prices of all units in the index. Perform this step as quickly as possible to ensure that prices you collected earlier do not change by the time you locate prices for items lower on the list.

5. Calculate a mathematical average of all of the prices. Set up your spreadsheet program to automatically calculate an average of the prices in your price column. If you are not using a spreadsheet, use the following formula to calculate a final value for the index, where N = the number of units in the index calculation: ( price #1 + price #2 + price #3... + price #N ) / N. In other words, add up the values of each price, from the first all the way to the last, then divide the sum by the number of units in the calculation. For example, if you have 20 listings in your index, add up the prices of all 20 units, then divide the sum by 20.

Tip

• Revisit your index on a regular basis, using your existing spreadsheet to update prices or add and remove items from the list. Keeping track of the percentage changes in the index value can give you insight into whatever market you are analyzing. When the value of the index changes, use the following formula to determine the percentage change: ( old value – new value ) / old value