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.
Market Capitalization
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.
Market Weighting
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.
Selection Process
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.
Author Bio:
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.