Understanding the S&P 500: How It's Calculated and Why It Matters

The S&P 500 is a bellwether of the U.S. economy, tracking the performance of 500 large companies across different industries. It’s often seen as a more accurate reflection of the overall market than the Dow Jones Industrial Average (DJIA). Companies are added or removed based on factors like market size, profitability, and liquidity. The index’s value is calculated using market capitalization and adjusted for the number of shares available to the public, known as float-adjustment. This article also explores how investors can use the S&P 500 in their strategies through index funds and ETFs.

Understanding the S&P 500 Index 

First, the etymology of the term: S&P stands for Standard and Poor’s. Henry Poor was a 19th-century financial analyst who compiled an annual book that listed publicly held railroad companies. His publication merged with those of the Standard Statistics Company in 1941. And 500 is the number of stocks that comprise the index.

That’s it. The index includes 500 of the largest (not necessarily the 500 largest) companies whose stocks trade on the New York Stock Exchange (NYSE), Nasdaq, or Chicago Board Options Exchange (CBOE). Like popes and Oscar winners, the components of the S&P 500 are selected by a committee. And, like the College of Cardinals and the Academy of Motion Picture Arts & Sciences, the S&P 500 committee operates within specific criteria. To qualify for the index, a company must have:

• A market cap of a certain size
• The value of its market capitalization traded annually
• At least a quarter-million of its shares traded in each of the previous six months
• Most of its shares in the public’s hands
• Had its initial public offering (IPO) at least one year earlier
• Have a positive sum of the previous four quarters of earnings, as well as the most recent quarter

Between them, the NYSE, Nasdaq, and CBOE list several thousand companies. But the first criterion alone reduces that number to less than a thousand. Add a few more benchmarks, and it’s easy to see how the S&P can get down to 500 large-cap stocks suitable for inclusion.

Calculating the S&P 500 Index Value

Unlike the Dow, which you calculate by just adding up the prices of the component stocks and multiplying by a constant, the S&P 500 is more complex. Several factors influence the index's value besides a company's share price. Instead of adding the constituents' stock prices, the S&P 500 adds the companies’ float-adjusted market capitalization. Also, the index does not include gains from cash dividends paid by the companies that comprise the index.

Float-adjusted means counting only the shares available to the public, excluding those held by management, governments, and other companies. There are hundreds of ostensibly publicly traded companies that keep most of their shares in-house.

Why Stocks Are Removed From the S&P 500

With so many components and such stringent criteria, the S&P 500 is dynamic. S&P Dow Jones Indices, the subsidiary of S&P Global that determines the components of the index, has little patience for slackers.

Case in point: United States Steel (X), one of the stalwarts of the 20th-century industry, was listed on the S&P 500 since its inception. In fact, at one point, the company was the largest company in the world. When it fell below the $4 billion threshold in 2013, the index gave it the boot and made room for Martin Marietta Materials (MLM), a construction aggregate producer.

Only on Wall Street does the Iron Age give way to the Stone Age.

But even technologically adept companies have to meet the S&P 500’s list of requirements. Turnover in the S&P 500 has been lower than you might think, but the length of time companies stay on the list is shrinking.

According to a study by McKinsey, the average lifespan of a company on the S&P 500 was 61 years in 1958. As of 2021, it was 16 years. The study also states that by 2027, 75% of the companies currently listed on the index will disappear.

Sometimes a company buys a company it replaces on the index or spins off a large chunk of itself. Other companies leave the list when they can no longer reach the market cap requirement. Typically, when that happens, the company is relegated to the index from which its replacement was promoted.

Is there a survivorship bias here? Sure, but there’s also a survivorship bias in the economy at large. The remaining stocks flourish by virtue of remaining. One study even claims that over the decades, stocks removed from the S&P 500 have ended up outperforming their replacements.

The Bottom Line

The S&P 500 serves as a key benchmark for measuring the health of the U.S. economy. It is comprehensive enough to reflect the performance of major industries yet focused enough to avoid unnecessary complexity. As a result, it stands as the leading index used by analysts, policymakers, and investors to gauge market trends and economic strength.

Correction—Nov. 16, 2023: This article has been corrected to state that the S&P 500 is comparable to the Russell 1000 index.