How Are S&P 500 Stocks Chosen?

Though the S&P 500 (^GSPC -0.22%) may include only a fraction of publicly traded companies by number, it is undoubtedly the most important index for U.S. stocks.

Together, the roughly 500 companies that make up the S&P 500 comprise more than 80% of the total value of all stocks on U.S. exchanges, making the index a go-to barometer for the performance of domestic stocks.

So how do companies get picked to join this exclusive list? It all boils down to meeting a few rules, and, most importantly, winning the favor of a committee of investors. Here's how it all works, item by item.

1. Market capitalization is an important filter

The S&P 500 is supposed to represent the largest U.S. companies, so naturally size is an important component. Size, in this case, is determined by the company's stock market value, or market capitalization, which is the total value of all its shares outstanding.

For example, Coca-Cola has roughly 4.3 billion shares of stock outstanding. As I write this, each share trades for $49. Therefore, its market cap stands at approximately $210 billion.

The cutoff for the S&P 500 moves up and down over time, but the current number to top is $6.1 billion. Of course, 20 years ago, that figure was much lower, and you'd expect that 20 years from now, that number will be much higher.

Image source: Getty Images.

2. Profitability matters...kind of

With few exceptions, companies must be profitable to get into the S&P 500 index. Profitability is measured in two ways: over the last four quarters and in the most recent quarter.

In theory, a company could lose $300 million in each of the first three quarters ($900 million total) and then post a $950 million profit in the final quarter, thus qualifying for the profitability test.

This is an extreme example to show how the profitability test isn't particularly demanding, since one quarter of profit could be good enough to meet the criteria. Companies that have recently gone public in an IPO must have at least 12 months of trading history on a large exchange, so a profitable company that goes public can't immediately hop into the S&P 500 based on its earnings before its IPO.

Check out all our earnings call transcripts.

3. Float and liquidity requirements are easy to check off

The purpose of the S&P 500 is to track large-cap stocks that you can actually invest in. To that end, it has some rules that disqualify companies that are closely held (majority owned by only a few shareholders) as well as companies that are thinly traded (companies whose shares have very little trading volume).

To get into the S&P 500, a company needs to have at least 50% of its stock "floating" on stock exchanges. Logically, it makes sense. A company that is 60% owned by its founder, for example, is arguably more "private" than "public" from an ownership perspective, given that only 40% of shares are in the hands of the investing public.

In addition to being majority owned by the public, a company's stock must be liquid. Each year, trading volume must exceed 100% of its float, and a minimum of 250,000 shares must trade in the six months leading up to the evaluation date. So if a company has 2 billion shares in the float, at least 2 billion shares must trade hands each year.

Frankly, most large companies check all these boxes without trying. There aren't many thinly traded, multibillion-dollar companies in which directors, officers, and other major shareholders own more than 50% of the company. And any company that is majority owned by the public will almost certainly pass the test for having ample trading volume.

4. A company must be American enough

The S&P 500 is meant to track large businesses that operate in the United States. To that end, it requires that companies meet some criteria for being U.S. businesses. A company must:

• File 10-K annual reports with the SEC.
• Have a "plurality" of assets and revenue in the United States.
• List on an eligible exchange (basically, any of the large exchanges such as the NYSE or NASDAQ)

There is a lot of wiggle room in these rules. The threshold for having a "plurality" of assets and revenue from the United States is not strictly defined. Companies may register overseas for tax purposes but still be considered U.S. companies for the purposes of getting into the S&P 500.

Perhaps the most strict rule is whether the company is listed on a large U.S. exchange and filing 10-K annual reports. The S&P 500 does not allow any companies that trade over the counter or on the pink sheets to get in.

5. Some companies get a free pass

Stocks that are part of the S&P MidCap 400 and S&P SmallCap 600 can get into the S&P 500 with fewer restrictions. These stocks aren't subject to rules relating to profitability, float, and/or liquidity. The thinking is that once a company joins any of these indexes, it should be able to move more freely between them.

Acquiring a company in one of these three indexes is an easier way in, as acquirers aren't subject to rules about profitability or having more than 50% of their shares floating on an exchange.

6. Some companies simply can't get in

The S&P 500 only includes ordinary corporations and real estate investment trusts (REITs). It excludes some more "exotic" structures, like business development companies (BDCs), master limited partnerships (MLPs), and limited liability companies (LLCs).

Of course, it also excludes closed-end funds (CEFs) and exchange-traded funds (ETFs) for the simple fact they mostly just hold other publicly traded stocks and bonds. Including S&P 500 ETFs in the S&P 500 would be...strange.

Some "normal" corporations are disallowed if they have multiple types of stock. For example, if Berkshire Hathaway weren't already in the index, it wouldn't be allowed in because it has Class A and Class B shares with different voting rights. This rule for companies with multiple share classes was put into place right before Snap's IPO in 2017, and it has been controversial, to say the least.

Dual-class share structures are extremely common in the technology world, with Alphabet, Square, Facebook, and others having multiple types of shares with different voting rights. Going forward, if a company isn't already in the S&P 500, having more than one class of stock will keep it out for good.

So far, this rule hasn't had a truly massive impact on the S&P 500 and its standing against other indexes, but it will almost certainly become more important over time, particularly if an especially large company is excluded from the index because it has a multiclass structure.

7. A committee makes the final decision

Meeting all the basic requirements isn't enough; companies must get the approval of the index committee to get into the S&P 500, making it more of an "active" index than other indexes that simply use mechanical rules to pick stocks. For example, the Russell 1000 doesn't have a committee. Either a company meets the mechanical rules or it doesn't.

The S&P 500 is supposed to be representative of the U.S. stock market. If tech stocks make up 40% of the S&P 500 when they make up 20% of the total value of all U.S. stocks, that's not ideal. The committee, by adding or removing stocks strategically, can ensure the S&P 500 doesn't differ meaningfully from the whole market.

A lot of money is invested in funds that track the S&P 500 -- Vanguard alone has more than $400 billion of assets in its S&P 500 funds -- so it's important to investors that the index accurately reflects the market.

At times, the committee has taken an active role in "managing" the index's composition. For example, during the 2008 financial crisis, the U.S. Treasury became a 90% owner of the insurance giant AIG, which would have normally disallowed it from being part of the index. David Blitzer, chairman of the index committee, explained in a blog post that the committee feared that removing AIG might have negatively affected the company and the shaky financial markets, so it kept AIG in the index.

In general, it's much harder to get kicked out of the S&P 500 than to get in, as S&P Dow Jones Indices explains in its methodology guide:

S&P Dow Jones Indices believes turnover in index membership should be avoided when possible. At times a stock may appear to temporarily violate one or more of the addition criteria. However, the addition criteria are for addition to an index, not for continued membership. As a result, an index constituent that appears to violate criteria for addition to that index is not deleted unless ongoing conditions warrant an index change.

Understandably, adding and removing companies from the S&P 500 is a big deal. With so many funds tracking it, changes can result in huge trading volumes as index funds sell stocks that are removed and purchase stocks that are added. Changes in the index can also trigger capital gains taxes for their investors, which is why many indexes and index funds seek to minimize turnover when possible.

In some way, the people who make up the index committee are some of the most influential people in the financial markets, responsible for decisions that can have billion-dollar consequences for investors.