How the Standard & Poors 500 (S&P 500) is composed by Hayley Spencer. The S&P 500 is an exclusive club that is made up of 500 companies and captures roughly 75 percent of publicly traded companies in the U.S. However, just because you own a business doesn't mean you get to be listed in the index. To get here, and play with the big boys, you have to be selected by a team of economists and analysts at Standard and Poor's. There's no application, and you can't just walk up to the door and knock. You have to be invited. If a company grows so large that it is eligible to be included in the index, the folks at S&P will notice.
The S&P 500 uses market capitalization to figure out who belongs in the index and who doesn't. The analysts and economists at S&P look for companies that have a value of more than $10 billion. If a company fails to meet this minimum standard, it doesn't make it into the index. The way the analysts figure out capitalization of a company is to take the number of outstanding shares in a corporation and multiply it by its stock price per share. The result is the market capitalization, also called "market cap."
Wal-Mart, Visa, The Hershey Company, and McDonald's are all examples of companies listed in the S&P 500 index.
Another factor that goes into the S&P 500, and that will ultimately determine who gets to stay and who must go is the market weighting. Market weighting is a way for analysts to calculate the returns of the index based on the market capitalization of the companies in the index. Obviously, S&P wants good companies with high market caps since the more of those that exist the stronger the index will be.
The way that S&P weights its index is by dividing the market cap of any given company by the total market capitalization of the entire index. The result is the weighting given to that company in the index. For example, if Exxon Mobile has a market cap of $367 billion and the S&P 500's total market capitalization (i.e. the value of all of the companies in the entire index) is $10 trillion, then analysts would divide $367 billion by $10 trillion. In this example, Exxon would have a weighting in the index of 3.45 percent. This means that Exxon effectively accounts for 3.45 percent of the total S&P 500 index when the company moves up or down in value.
Obviously, this also means that the largest companies in the index get the most weighting and smaller companies get less weighting in the index. If a company is too small, or analysts decide that it doesn't provide enough value to the index, the company may be dropped altogether.
Because the companies in the index are chosen by a committee, there is no official outside vetting process for entry into the index. S&P does maintain several indexes, and each one is comprised of different kinds of companies. All listings are determined, however, by a committee. Analysts want a stable index, so companies are chosen very carefully so as to reduce the odds of having to turn over companies in the index often. This helps to build stability into the index and creates authority in the investment community. S&P wants its 500 index to be considered the benchmark for performance in the U.S. economy. For the most part, it has earned a permanent place as "the" stock market index choice for investors.
Guest post contributed by Hayley Spencer for Easy Finance Home Loans. Hayley is a freelance business writer after a long standing career as a corporate consultant. Her articles appear on various business blogs.