about 3 years ago • 3 mins
Tesla’s accession to the S&P 500 on Monday made the top US stock market index – already close to its most expensive ever – appear even more pricey. It’s perhaps understandable, then, that some analysts worry that the electric car and battery maker will prove to be the straw that breaks the camel’s back, causing investors to balk at high valuations and sell off stocks across the board. A detailed look at how S&P 500 valuation metrics are actually calculated, however, suggests there’s much less to worry about than they think.
Let’s start off with a few stats. Tesla’s market capitalization is about $600 billion and its “float cap” – the value of all shares that can be easily exchanged on stock markets – is $480 billion. The latter figure is used to determine the company’s weighting in the S&P 500, meaning Tesla will represent around 1.5% of the index.
Looking at Tesla’s valuation is what’s got some investors worried: its price-to-earnings (P/E) ratio is around 160, so a back-of-the-envelope calculation (160 x 1.5%) indicates the stock’s inclusion will add at least another 2 to the overall S&P 500’s previous P/E ratio of roughly 22 – already near record highs.
In reality, however, Tesla should only raise the index’s valuation ratio by 0.4. Here’s what many people seem to be missing: while companies in the S&P 500 are weighted by relative size, valuation metrics aren’t – and that distinction’s mathematically important.
Calculating the index’s earnings per share (EPS) involves adding together the profits of all its 500 companies and then scaling that down to a "per share" number weighted according to the float cap mentioned above. The 500 firms’ combined market capitalization is then divided by that figure to arrive at the S&P 500’s P/E ratio – thus giving an earnings-weighted measure rather than a size-weighted one.
Applying that to Tesla means its 1.5% market cap weight in the index translates to a 0.2% earnings weighting, based on analysts’ average profit prediction for the company next year. So regardless of whether the stock’s individual P/E ratio was 160 or even 500, its impact on the S&P 500’s overall P/E ratio would still only be an increase of about 0.4.
While you can calculate the S&P 500’s P/E ratio in the quickfire way first mentioned – and several investors have done just that – understanding this more relevant valuation approach may just give you an edge on others, at least when it comes to thinking through the effects of Tesla joining the index.
Tesla’s inclusion in the S&P 500 won’t be a non-event, though: it’ll certainly play a role in the index’s future performance. The company’s high-voltage stock has risen some 684% this year, outstripping the S&P 500 by 669 percentage points. Indeed, if Tesla had been part of the index all year then the S&P 500 could have been up 17% at this stage instead of 15%. There would, however, have been even more bumps along the way along the way – and the addition of Tesla’s oft-swinging stock will lead to the key VIX measure of US stock price volatility nudging higher in 2021.
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