Shopify Inc. (NYSE:SHOP) could be in for a nice surprise. The company may benefit from new rules being considered by Canada's most popular stock index, the S&P/TSX Composite Index, which is operated by S&P Dow Jones Indices on the Toronto Stock Exchange. If approved, the rule change could add Shopify to the index as early as this September and boost demand for the company's shares as the index is purchased by many looking to track the broad Canadian market. 

Shopify's headquarters are in Ontario, Canada. Its stock trades on both the Toronto Stock Exchange and the New York Stock Exchange in what is known as a dual listing. This allows investors in both countries to have easy access to the stock.

Shopify employees outside Toronto Stock Exchange on IPO day.

Shopify trades on both the Toronto Stock Exchange and the New York Stock Exchange. Image source: Toronto Stock Exchange.

What is the new rule all about?

The current method for a company to be included in the Canadian index is based on its trading volume on the Canadian index alone. This is not very fair to dual-listed companies, for which trading is naturally going to be split if the shares are available on a United States exchange. The new rule would add the U.S.-based trading volume to the trades made on the Canadian exchange. The proposal to make the change is currently out for comment through June 9.   

Why is this good news for Shopify?

Scotia Capital Incorporated, a Canadian investment bank, believes Shopify would immediately qualify for inclusion into the S&P/TSX composite index if the new rule is enacted. There is also the possibility that Shopify's current trading volume under existing exchange rules may qualify it to be added to the index without a rule change as early as this June, according to Scotia Capital.  Either way, it looks like Shopify may be entering the index -- and that is great news for shareholders.

Index funds will come knocking

Assuming Shopify enters the index, Scotia Capital estimates that passive index funds will need to buy about 5% of Shopify stock as index funds are required to have an ownership ratio of each stock that makes up the index that mimics the index. After the recent secondary offering, that would be equal to a demand of about 5.4 million Shopify shares, worth approximately $490 million.

Below is a chart showing Shopify's trading volume on both exchanges.

Exchange Average Daily Trading Volume
New York Stock Exchange 2.4 million shares
Toronto Stock Exchange 0.4 million shares
Total 2.8 million shares

Data source: Google finance. Chart by author.

The need to buy 5.4 million shares is equal to about two days of Shopify average trading volume. 

This additional demand for the stock should cause the price to increase initially and may have a lasting effect, as more investors are turning to passive index investing. 

How does Shopify benefit?

Initially, all the benefit will go to current shareholders, as the shares purchased for index funds will come from the shares that are already trading in the stock market in both countries. None of the money will go to the company itself.

The company employees will benefit if the stock price goes higher, as their outstanding stock options will increase in value. As they say, a happy employee is a productive employee, so the company may reap some benefit indirectly from its pool of employees.

The other area where the company may benefit is if it does any follow-on offerings of stock, as it did in August 2016 and most recently in May 2017. In both cases, the company issued new shares, sold them in the market, and used the proceeds to grow its business. The higher the stock price, the more money the company can raise for each share it sells.

From an investing perspective, shareholders like higher stock prices, and it looks like Shopify shareholders are about to be given a gift if the company joins the index. Keep in mind, however, this has nothing to do with the fundamentals of Shopify. This simply is a short-term requirement to purchase shares by index funds. Long-term it will be back to basics and the stock will trade around how well the company runs as a business.