Introduction
The weighted average is a measure that takes into consideration the different degrees of the numbers in a data set. When calculating a weighted average, before the final calculation is completed, each number in the data set is multiplied by a predetermined weight. A weighted average can be more accurate than a simple average which assigns equal weight to all numbers in a data set.
Understanding Weighted Average
All numbers are treated equally and assigned equal weight in the calculation of a simple average, or arithmetical mean. Nonetheless, a weighted average assigns weights which decide the relative importance of each data point in advance.
Investors typically construct a stock position over a several-year span, which makes it challenging to keep track of the cost base on those shares and their relative value shifts.
The investor will calculate a weighted average of the price of the shares. To do so, multiply by that price, the number of shares purchased at each point, add those values and then divide the total value by the total number of shares.
Examples
Besides the selling price of securities, weighted averages exist in many aspects of finance, including equity returns, inventory accounting, and valuation. Whenever a fund holding several securities is up 10% year-on-year, the 10% reflects a weighted average return for the investment compared to the value of each position in the portfolio.
For inventory accounting, for example, the weighted average value of inventory accounts for fluctuations in product prices. In contrast, approaches, such as LIFO (Last In First Out) or FIFO (First In First Out) offer higher priority to time than value.
When evaluating companies to determine if their shares are priced appropriately, investors use the weighted average capital cost (WACC) to discount cash flows from a company. WACC is weighted based on the market value of debt and equity in a company's capital structure.
