Facebook and the S&P 500

Question: I heard that Facebook (FB) will soon be added to the S&P 500 even though the company went public just last year. What are the rules regarding when a company joins or leaves the index?

Answer: Given the S&P 500's role as one of the most widely used measures of U.S. stock market performance, one might assume that the index's composition doesn't change much from year to year, but that's not necessarily the case. In fact, this year alone [2013] the S&P 500, which tracks the stocks of many of the largest U.S. companies and weights them by market value, has already swapped out 15 constituent companies in exchange for others.

Companies added in 2013 include clothing maker Michael Kors Holdings (KORS), Delta Air Lines (DAL), News Corp (NWSA), oil-services company Transocean (RIG), and Vertex Pharmaceuticals (VRTX). Meanwhile, those leaving the index included Dell, Sprint (S), J.C. Penney (JCP), Dean Foods (DF), and NYSE Euronext. The index will change further Dec. 20 as social-media giant Facebook, marketing and loyalty-program services firm Alliance Data Systems (ADS), and flooring manufacturer Mohawk Industries (MHK) join the index, replacing Teradyne (TER), Abercrombie & Fitch (ANF), and JDS Uniphase (JDSU).

According to the S&P Dow Jones Indices website, the composition of the S&P 500 is maintained by a committee of economists and analysts whose goal is "to ensure that the S&P 500 remains a leading indicator of U.S. equities, reflecting the risk and return characteristics of the broader large-cap universe on an ongoing basis."

To be included in the index, companies must meet the following criteria:

• Must be a U.S. company
• Must have a market capitalization of at least $4.6 billion (the limit as of September but subject to change)
• At least 50% of the company must be publicly held
• Must have four consecutive quarters of positive reported earnings
• Stock must be relatively liquid, trading at least 250,000 shares per month for six months
• Company must contribute to the index's sector balance
• Must be listed on the New York Stock Exchange or Nasdaq, or be a non-mortgage REIT or business-development company

Companies may be booted from the index for violating any of the above criteria. For example, J.C. Penney, the struggling department store chain that has seen its market cap plummet from $7.5 billion to $2.6 billion in just two years, got the boot last month (at the same time it was added to the S&P MidCap 400 Index). These criteria also came into play during the late 1990s, when many tech companies saw their stock prices soar, lifting their market capitalizations to well within range of the index. Yet those companies were left out because they didn't meet the index's profitability rules.

The index committee takes into account short- and medium-term historical market-cap trends for a company and its industry before adding it to the S&P 500. The index's methodology states that following an IPO, companies must wait at least six to 12 months before being considered for the index. Members obviously believed that Facebook, with a market cap of around $130 billion, was ready despite its relatively short history as a public company; Facebook's IPO took place in May 2012. Changes to the index are made as needed and not on any set schedule, according to the methodology.