In September 2020, e-commerce company Etsy(NASDAQ: ETSY) was included in the S&P 500 -- an index of about 500 of the biggest, most profitable U.S. companies. Indeed, 2020 was a bumper year for the company, with revenue more than doubling from 2019. The booming business earned about $350 million in net income from the year, which is likely why it was deemed a good candidate for the S&P 500.
According to a recent study by McKinsey, a company stays in the S&P 500 for about 16 years after initially earning inclusion. But Etsy didn't even come close to this number. S&P Global has announced that Etsy is getting removed from the index on Sept. 23 -- just four years after joining.
Etsy stock is down more than 80% from its all-time high reached in 2021. And if that's not discouraging enough, shareholders now have to deal with its short-lived tenure in the S&P 500. But this news surprisingly predicts better days right around the corner. Here's why.
Why is Etsy getting kicked out of the S&P 500?
A company's size and its profitability are two of the biggest factors for inclusion in the S&P 500. When it comes to Etsy, it's still a profitable business. It earned $116 million in net income in the first half of 2024. That was down 15% from the first half of 2023. But this marketplace business for handcrafted goods is still profitable, nevertheless.
Many companies get kicked out of the S&P 500 for troubling reasons. Sometimes they hit material struggles. Businesses can become unprofitable, they can put themselves up for sale, and they sometimes even go out of business. None of that happened with Etsy.
The primary reason Etsy stock is leaving the S&P 500 is its market capitalization -- the value of the company. When it was initially included, the market capitalizatioin was around $15 billion, and it would eventually surpass $30 billion. But now Etsy's market cap has plunged to about $6 billion, as the chart below shows.
ETSY Market Cap data by YCharts.
According to Finviz, this makes Etsy the second smallest stock in the S&P 500 right now, barely ahead of Bath & Body Works. That's just too small to warrant ongoing inclusion. Therefore, S&P Global is moving Etsy stock to the S&P SmallCap 600.
If Etsy were being removed from the S&P 500 index for more serious reasons, this would be a different discussion. But the reality is that it's simply too small to be there. That's why I find this an interesting situation.
Why better days might be ahead for Etsy stock
According to recent research from Rob Arnott of Research Affiliates, stocks that get removed from the S&P 500 actually outperform the index on average for the next five years. This is partly because investors tend to be overly pessimistic about a company around the time it's getting removed. And when investors are overly pessimistic, stocks tend to be undervalued.
Indeed, there's a strong chance that Etsy stock is undervalued today. Stocks can be valued from various metrics. But the stock trades below its five-year average valuation from a sales perspective, an earnings perspective, and a free cash flow perspective.
ETSY PS Ratio data by YCharts.
To reiterate, this would be completely different if Etsy had fallen on hard times. If it were losing market share to a competitor, losing money, or facing litigation, it wouldn't really matter whether the stock was cheap or not. These things would represent a bad situation for the business.
In contrast, Etsy's key metrics are actually modestly encouraging. In the company's second quarter, its base of active sellers and active buyers continued to grow. Spending per active buyer admittedly slipped slightly. But that's far less troubling than if buyers had left the platform altogether. Moreover, it still grew Q2 revenue by 3% due to increased revenue from the services it provides to sellers.
Etsy's Q2 net income was down year over year, which some might find problematic. But this is merely a tax-timing issue. Measuring profitability from a different perspective, the company's operating income of $159 million in the first half of 2024 is up significantly from its operating income of $87 million in the first half of 2023.
The business is stable and profitable. But its valuation has dropped drastically in recent years because investors are increasingly bearish about its long-term prospects. In contrast, I believe the business is fine and will return to growth, and that the stock is consequently undervalued today. That sets it up nicely to outperform the S&P 500 over the next five years, just like past S&P 500 rejects.
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Jon Quast has positions in Etsy. The Motley Fool has positions in and recommends Etsy and S&P Global. The Motley Fool has a disclosure policy.
