What will it take for DroneShield shares to enter the ASX 200?

DroneShield shares are up 710% in a year. So why aren't they in the ASX 200 yet?

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DroneShield Ltd (ASX: DRO) shares have enjoyed one of the most euphoric share price runs of any stock in the All Ordinaries Index (ASX: XAO) over the past 12 months.

A year ago, Droneshield shares were going for just 24 cents apiece. But fast forward to today, and those same shares are worth an extraordinary $1.94. That translates into a 12-month share price gain of 710%.

The gains are even larger for longer-term investors of this ASX defence share.

If one had owned Droneshield stock since April of 2020, when this company was priced at just 10 cents a share, they would be looking at a four-and-a-bit-year gain of 1,840%.

This stunning run leaves Droneshield with a respectable market capitalisation of $1.53 billion today.

With this kind of market cap under Droneshield's belt, many investors might be wondering why Droneshield shares aren't in the exclusive S&P/ASX 200 Index (ASX: XJO) club. After all, the ASX 200 is supposed to represent the largest 200 companies listed on the Australian share market.

And with a market cap of $1.53 billion, Droneshield is now well within that range.

On the surface, it does look like Droneshield's ASX 200 inclusion is well overdue.

This company is now double the size of some of the ASX 200's smallest constituents. Take Strike Energy Ltd (ASX: STX). Strike shares only joined the ASX 200 in February of this year, replacing the now-taken-over Costa Group Holdings Ltd.  But today, Strike has a market capitalisation of just $643.7 million – less than half of Droneshield.

Another stock currently in the bottom realms of the ASX is Nanosonics Ltd (ASX: NAN). Nanosonics currently commands a market cap of $884.75 million. Yet it too finds itself in the ASX 200, whereas Droneshield shares do not.

So what's going on here?

Why aren't Droneshield shares in the ASX 200?

Well, the ASX 200 Index is a little more complicated than what investors might naturally assume. It is not simply a collection of the largest 200 shares on the Australian market. S&P Global, the company that manages most of the ASX's indexes, lists several criteria for ASX 200 inclusion, of which market capitalisation is just one.

And even though a company's market cap is an important factor, S&P Global doesn't just automatically include a share when it reaches a certain market cap milestone in its next quarterly rebalancing.

Here's what S&P Global says on that:

…the market capitalization criterion for stock inclusion is based upon the daily average market capitalization of a security over the last six months.

The ASX stock price history (last six months, adjusted for price- adjusting corporate actions), latest available shares on issue, and the Investable Weight Factor (IWF) are the relevant variables for the calculation.

Today, Droneshield's market cap is 440% higher than it was six months ago, which is one possible reason it hasn't yet found itself in the ASX 200 Index.

S&P Global also uses liquidity as a test for ASX 200 inclusion. And Droneshield is now a very liquid stock by ASX standards, with more than 10 million shares traded so far this Friday. So it's likely that Droneshield's liquidity isn't a factor here.

But S&P Global also uses another selection criterion for ASX 200 inclusion which might explain Droneshield's absence in the index:

In order to limit the level of index turnover, eligible non-constituent securities will generally only
be considered for index inclusion once a current constituent stock is excluded due to a sufficiently low rank and/or liquidity, based on the float-adjusted market capitalization.

Remember we discussed Strike Energy's ASX 200 inclusion? Well, that only happened thanks to Costa Group leaving the index. It looks as though it's not Droneshield's attributes that are resulting in its index exclusion today, but the attributes of the other shares on the index.

Next time a share is taken off the ASX boards or fails to meet the index's market capitalisation and liquidity requirements, it might be Droneshield shares' best shot at becoming an ASX 200 share. But until that happens, we might not see this company within the index. Watch this space.

Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended DroneShield, Nanosonics, and S&P Global. The Motley Fool Australia has positions in and has recommended Nanosonics. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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