The S&P 500 is a frequently updated market index of the 500 biggest large-cap, publicly traded American companies. Multiple companies are added to and removed from the S&P 500 every year. Companies like Peabody Energy, JCPenney, or Avon made headlines in recent years when they were delisted from the index.

In this video segment, Gaby Lapera and John Maxfield thoroughly explain the five qualifications that companies need to meet to stay in the index (and the underlying rationale behind them), when exceptions to the rules are allowed, and what it takes for companies to finally be taken off the list.

A transcript follows the video.

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This podcast was recorded on Feb. 2, 2016. 

Gaby Lapera: The first question we got is from Rob Waters: Why are stocks delisted? Originally, that was "Why are stocks delisted from the Dow?" but we decided to do why are stocks delisted from the S&P, just because it's a better broad index than the Dow. So, in the last few years, I don't think that many stocks have been delisted, but the ones you may have heard of that you probably know would be like a JCPenney, or, I think, Avon was delisted in 2015.

There are five basic qualifications that the S&P has for stocks, that they need to fulfill, generally -- we'll get to some of the exceptions in a bit -- in order to stay within the index. The first is that the S&P is a large-cap index, and they generally want companies to be above $5.3 billion in order to stay on there.

John Maxfield: And that's $5.3 billion in market cap. And just to reiterate Gaby's point, you know that saying in the "Pirates of the Caribbean" movie? I can't remember which pirate it was, he was like, "Oh, this is more guidelines, as opposed to hard and fast rules." So, each of these things that we'll go through, each of these five components that we're going to talk about that she noted, all of these are just guidelines, as opposed to hard and fast rules.

Lapera: Absolutely. Generally, the exceptions come when the market is not doing great, and if they were to strictly adhere to all of the guidelines, there wouldn't be anyone in the S&P, and that would not be great for the S&P, right? So, there's a little bit of flexibility here. The second guideline -- the first, I'd like to remind you, is that it need to have a market cap of $5.3 billion or above -- the second is liquidity.

The stocks need to have traded at a minimum of 250,000 shares over a 6-month period leading up to the evaluation. I think the example we were talking about earlier, John, was Berkshire Hathaway (BRK.A -1.12%) (BRK.B -0.86%), which is a great company. People know about it, it's really stable, but for the longest time, it was not in the S&P 500 because shares were so expensive that people couldn't afford to trade them easily.

Maxfield: Yeah. It's one of those really ironic things. When you think of our biggest and best large-cap companies in the United States, certainly Berkshire Hathaway is at the top of that, right? But the problem with that is, its shares, for all of these years -- well, not all these years, but for multiple years -- traded above $100,000 per share.

And it wasn't until 2010 when Berkshire purchased Burlington Northern Santa Fe, the railroad, that they did a stock split that then created a second category of shares that then trade for much, much less. And that's what has made it possible for individual investors to buy and sell it, which boosted its volume, which then qualified it for inclusion on the S&P 500.

Lapera: Another thing that all the companies on the S&P have in common is that they must be domiciled in the U.S. They define this in various ways. They have to file a 10-K, and then, they say you have to have a plurality of revenue and assets that are based in the U.S., or your headquarters must be in the U.S. Do you want to expand a little bit on why they have it that way?

Maxfield: This is a large-cap American index. So, what they mean by plurality is -- as a lawyer, this is something I'm relatively familiar with, because it comes into play in Supreme Court decisions -- but, what plurality means is, you don't have to have a majority, which would be at least 51%; but if you have, say, assets in five different countries, and, say, 40% of your assets are in the United States, and, whatever that would be, 15% or so in each of the other ones -- a plurality means the largest of the group. So, because it's a large-cap index that's based in the United States, they want, at least, of all the countries that you're exposed to, they want the largest share to be in the United States.

Lapera: Right. And this has something to do with avoiding tax laws and stuff like that, too. So, some people will register their companies in, say, Hong Kong or Ireland because taxes are less. And it gets complicated. But in general, that's what they want -- they want the companies to basically be based in the United States. The stocks, to stay in the S&P, have to be listed on the NASDAQ or the Dow. And, they must also have a corporate governance structure consistent with U.S. companies.

Maxfield: You fill in the blanks there.

Lapera: (laughs) Yeah, I have no idea what that means.

Maxfield: Does that mean, like, Enron? (laughs)

Lapera: (laughs) Oh, god.

Maxfield: Or does that mean Berkshire Hathaway? You know what I mean? It seems like the continuum there is probably pretty broad. But I think the point they're trying to make is that they want you to follow the same country guidelines, and they want you to abide by, at least, the same concept of how you should be operating ethically.

Lapera: Right. Just, like, a general, and something that's written down so people can look at it, as opposed to shadowy backdoor dealings. I think that's what they're trying to get at with that last one. So, so far, we've covered large-cap index, liquidity, domicile. The company must have a public float of at least 50% of their stock. Do you want to expound on that?

Maxfield: Yeah. When a company goes public -- Goldman Sachs (GS -0.30%) is a good example. When it went public in, I think it was 1999, they don't list 100% of the company. They'll list, like ... I can't remember what it was with Goldman Sachs, but it was a pretty small percentage, maybe 5% or 10%, something like that. The rest of that, that 90%, whatever that remainder is, is non-floated stock, it's not traded on the active exchange.

Well, the S&P 500 wants companies that have at least 50% of that that's floated. Now, like, Goldman Sachs and their situation, that float has increased over time as their partners at the time of the IPO have sold out their positions and retired and diversified their assets and stuff like that. But, just, the idea is, you want these to be public companies that are highly liquid, and in order for those things to come into play, you need a large float.

Lapera: Right. And that ties a little bit into the last one, which is financial viability. This is probably the most common reason for stocks to get delisted, is that there's something fundamentally wrong with them. I think one of the latest stocks to be delisted was Peabody Energy, and you saw that their credit rating just got bumped and bumped and bumped again, all downward. So, they have to have positive earnings over the last four quarters, and they have to have good credit ratings. They just have to seem like a fundamentally sound business in general. Right?

Maxfield: Right. Exactly. Again, this is a general rule. You don't want the S&P 500 to be full of these companies that don't make any money, right? What would that say about an index that's supposed to track the large-cap sector of the United States, our biggest and best companies? But again, the way the S&P lays its methodologies out, it says, you have to have positive earnings over the last four quarters.

If you look back to the financial crisis, and you were a stickler on that, the S&P 500 would be the S&P 5. (laughs) You know? So you don't want to push it so far that it would defeat the whole purpose of the thing. But as a general rule, what they're getting at here is that they want good companies that adequately represent what America's biggest and best companies, for lack of a better term, represent.

Lapera: Right. And I'm going to say that, in general, I haven't ever seen the S&P delist a company and someone say, "Oh, that was vindictive." It's always like, "Yeah, we kind of saw that coming." You know what I mean?

Maxfield: Yeah. That's exactly right. JCPenney's, a few years ago, it's going down, going down, going down, and the S&P 500 were finally just like, "Okay, fine, we have to get rid of these guys, it's getting pretty ugly here."

Lapera: Oh, and, fun fact, when someone gets delisted, someone else can come on.

Maxfield: That's exactly right, because it has to stay at 500.

Lapera: Exactly. You can't have 501, that would be absurd (laughs).

Maxfield: I mean, you could, but you'd have to change the name.