Try this simple thought experiment: imagine you are valuing a company, and you know with absolute certainty the company’s financial results for the next ten years, its debt-to-equity mix over that time, its beta, and its costs of debt and equity. Moreover, you have perfect information about the company’s peers. In fact, you’re missing only one data point—whether or not the company is included on a major stock index (such as the S&P 500 or the FTSE 100). How confident would you be about your valuation?
If you said very confident, congratulations; logically and empirically, index inclusion does not affect intrinsic value. If you hesitated, that’s also understandable. In a sense, the market hesitates, too. When an index announces that it is including or removing a company, the company’s stock price does move—increasing for inclusion, declining for removal. But then the stock price readjusts, typically within two months, as the market moves ineluctably toward the company’s intrinsic value.
We recently analyzed the total shareholder returns (TSR) of hundreds of companies that were included or excluded from the S&P 500 over the history of the index and found that this readjustment still holds true (exhibit). Moreover, the magnitude of change is declining, as investors increasingly anchor on business fundamentals.1 Index inclusion or removal follows TSR performance, not the other way around.
Precisely because the index effect is ephemeral, boards should not strive for it, and managers should not build a strategy with indexes in mind. For example, companies shouldn’t refrain from spin-offs or divestments merely because, by being smaller, they may not be included in an index. Nor, on the other hand, should they pursue share issuances, mergers, or acquisitions for index-related reasons. As a tactical matter, however, they should recognize that whether or not a company is included in an index can, for a short time, affect price—a consideration that matters when key events such as equity issuances or M&A transactions occur.
In terms of investor communications, they should be frank with analysts and investors in explaining that boosts from index inclusions, or declines from index removals, won’t create a “new normal” for share price expectations. Instead, they should consistently emphasize that intrinsic value is driven by growth, ROIC, and broader sectoral trends. After all, no one should build a valuation model with “index” as an input.
