One of America’s leading and most trusted stock market indices, S&P 500 tracks the stocks of US’s 505 large-cap companies. It is seen as a bellwether for the US economy since it represents the performance of some of the country’s largest companies.

S&P500: Features Of The Index

S&P500, owned by S&P Down Jones Indices currently, is the performance benchmark that investors use to compare all investments to, to gauge profits and see how the overall market fares. A portfolio manager aims to beat the performance of the benchmark S&P500 index.

The index has a great representational value because it covers 80 percent of the total market capitalisation. The index, which was officially launched on March 4, 1957, derives its value from the value of the underlying stocks and so it is dynamic. The index is owned by S&P Dow Jones indices currently.

How Does the Index Work?

To know what the index does, it is important to know what market capitalisation (cap) is. Market cap is the total value of all the shares of a company being traded. It is derived by multiplying the number of shares available in the market to the stock price per share. The index tracks and enlists large-cap companies based on the size of the market cap. For example, a company with a $200 billion market cap will have 10X representation in the index over a company with a market cap of $20 billion. In March 2020, for example, the index boasted of a total market cap of $21.42 trillion, which is a 9.2 percent decline from one year ago in 2019 when the market cap had clocked $23.62 trillion.

How Is the Value Of S&P500 Calculated?

The index is valued using free-float market capitalisation method, which means, the value of the underlying stock is derived by multiplying the stock price per share with the total number of outstanding shares being traded in the public exclusively. This method does not include the number of shares held by promoters, government or private parties.

How are the market weights calculated?

Step 1 Calculate the total market cap of each large-cap stock in the index

Let us consider an example of Apple which has a significant market weight in the index.

Now, by end of 2018, Apple had 4.8 billion publicly traded shares and each share traded at $149. So Apple’s total free-float market cap would be each share price multiplied by the total number of publicly traded shares that is $712 billion.

Step 2 Calculate total market cap of all the stocks

To calculate the total market cap of the index, the market cap of all the 500-505 companies included in the index can be added.

Step 3 Calculate Individual Market Weights

It is important to calculate the individual market weights to know how much stock of one company influences the value of the index.

You can derive individual market weights simply by dividing the free-float market cap of an individual stock by total S&P500 market cap. For example, in March 2020, Microsoft Corporation held 5.4 percent of the total market weight in S&P500, Apple Inc, Amazon.com Inc and Facebook held 4.8 percent, 3.6 percent and 1.8 percent of the market weights in the index respectively.  Logically, more the market weight, more percentage changes in its stock price will affect the value of the index itself.

The index is recalibrated each quarter in months of March, June, September and December. The sector-wise break down is also liable to change. In March 2020 for example, IT and IT-enabled services constituted 24.4 percent of the stocks in the index, healthcare- 14 percent, financial services- 12.2 percent, consumer stables- 7.2 percent, real estate 3.1 percent, among other sectors.

What Is the Index Divisor?

When the value of the index is calculated using price-weighted aggregate methodology, to keep the calculations of the index’s value manageable, the index uses a proprietary value or the index divisor to strip down the index to a reportable scale. How this is done is, when an index is first formulated, we simply add up the prices of all the stocks in the index which gives us the initial value of the index. Now as large companies with large market caps enter the foray to make calculations less cumbersome, the index divisor is applied to strip down the added value of all the stock prices to a usable value that is easy to track and remember. Another purpose served by the divisor is that it minimises the influence of stock splits, dividends, and buybacks on the overall value of the index.

Qualifications for a Company to be Listed on S&P 500

For a company to find a place in the S&P500 Index, it must meet these requirements. Meeting these requirements alone will not automatically qualify a company to be listed on the exchange. Based on companies that meet the criteria below, a high powered committee picks companies based on their industry, size and how liquid these companies are to be truly representational.

1. The company must be based out of the United States.

2. As of 2020, it should have a market cap (unadjusted) worth $8.2 billion at least.

3. The stock price must be $1 or higher, per share.

4. Should be filing 10K annual report

5. 50 percent of the assets and revenues must come from within the United States.

6. 50 percent of the company’s stock must be publicly tradable.

7. Should have reported four consecutive quarters of positive net profits.

Shouldn’t be on a pink sheet. In other words, the stock should not be on lists of stocks traded over the counter. Should be listed on NYSE (New York Stock Exchange), Investors Exchange, Nasdaq, or BATS Global Markets.

Other Competing Market Indices

The second most significant stock market index in the US is the Dow Jones Industrial Average or the Dow that represents 30 large-cap industry leading stocks. It has far fewer shares than S &P 500 and is, therefore, less representational of the entire stock market. Secondly, it does not use the free-floated market-cap-weighted method to calculate the market weights of the stocks included. The Dow’s total market cap is about one-fourth of the entire US stock market cap. The way S&P500 differs from Nasdaq Composite, another leading US stock index, is that unlike S&P500 it also includes privately traded shares. Led by market forces, these indices tend to move more or less in tandem as far as the direction of the market is concerned.

Conclusion:

Understanding the workings of S&P500 is key to understanding the US economy and markets given its directional value. Whether an economy is potentially headed into a recession or is emerging out of it, the index will reflect it. The S&P500 stocks also headline market movements because they comprise 80 percent of the entire market cap.