Loyola University Chicago School of Law, JD 2022
Tesla satisfied the final requirement to join the S&P 500 when it announced its fourth consecutive quarter of profitability on July 22, 2020. As a result, investors speculated that the electric car maker would be added to the index in short order. However, on September 4, 2020, the U.S. Index Committee, the group responsible for managing the index, announced the addition of three new companies without mentioning Tesla. The news led to a 21% decline in Tesla’s stock price, the largest drop in the company’s history.
What is the S&P 500?
In its simplest from, the S&P 500 is a stock index. A stock index is a compilation of stocks constructed to replicate a particular market, sector, commodity, or anything else an investor might want to track.
The S&P 500 Index is comprised of 500 of the largest U.S. publicly traded companies in terms of market capitalization. Market capitalization is calculated by multiplying the number of shares issued by the stock price. In other words, market capitalization is the total value of all the shares of stock a company has issued. Thus, the index represents the stock market’s performance by reporting the risks and returns of the biggest companies. Investors use the S&P 500 as the benchmark of the overall market.
How is the makeup of the index determined?
The U.S. Index Committee selects each of the index’s 500 companies based on their liquidity, size, and industry. In March, June, September, and December of each year the committee rebalances the index by removing some companies and adding others.
To qualify for inclusion in the S&P 500, a company must satisfy the following requirements:
- The company must operate in the United States;
- The company must have a market capitalization of at least $8.2 billion;
- At least 50% of the company’s stock must be available to the public;
- The company’s stock price must be at least $l per share;
- The company must file a 10-K annual report;
- At least 50% of the company’s fixed assets and revenues must be in the United States; and
- The company must have at least four consecutive quarters of positive earnings.
What was Tesla’s case for inclusion in the S&P 500?
On September 4, 2020, the day the S&P 500 Index Committee announced that Tesla would not be included in the index, Tesla’s market capitalization was $390.52 billion, making it the ninth largest publicly traded company based in the U.S. by that metric. The electric auto maker is now worth more than some of the world’s largest car companies, including Toyota and Volkswagen. In addition, Tesla’s stock price has been on a tear this year, having risen around 300%. Finally, the company reported its fourth consecutive quarter of profitability in July.
In short, Tesla would have been the largest company to ever join the index.
Why was Tesla excluded?
Despite meeting all the requirements for inclusion in the S&P 500, and the stellar performance of Tesla stock, the committee decided to add online marketplace Etsy, Inc., technology firm Teradyne Inc., and pharmaceutical company Catalent Inc., while Tesla was excluded.
Wall Street analysts have identified a few factors that potentially contributed to the committee’s decision. Namely, Tesla’s positive profitability has been driven by the sale of regulatory credits to other auto manufacturers who need offsets in order to reach their emission standards. Tesla made more than $1 billion from the sale of regulatory credits over the past four quarters, more than double its profits over the past four quarters. Simply put, the quality of Tesla’s earning might have been an issue for the committee. On other hand, some analysts have speculated that the decision by the committee was due to a collective view that Tesla stock is severely overvalued.
What will happen when Tesla does join the S&P 500?
Tesla remains eligible for inclusion in the S&P 500 if it continues to stay profitable in future quarters. Despite missing the party this time, it seems inevitable that the flashy car maker will be added to the index in the near future.
When Tesla is added to the index, its stock price will undoubtedly see an even larger boost. When companies are added to a stock index, all the funds that track the index have to purchase the company’s stock. This results in an influx of tens of billions of dollars into the stock over the span of a few weeks.
What message did the S&P 500 committee send?
2020 has been a wild year for the stock market. Stock prices have soared, plummeted, and then soared again. Through it all, Tesla has been the prime example of extreme growth coupled with extreme volatility. Maybe the S&P 500 Committee sought to bring investors back down to earth by reminding them that fundamental financials should dictate stock price. In doing so, the S&P 500 engaged in regulatory decision making that resulted in a widespread market response.