What Is Free-Float Methodology?
The free-float approach is a method for estimating the market capitalization of underlying firms in a stock market index. Market capitalization is computed using the free-float approach by multiplying the equity’s price by the number of shares easily accessible in the market.
The free-float technique eliminates locked-in shares, such as those owned by insiders, promoters, and governments, rather than utilizing all of the shares (including active and inactive shares) as the full-market capitalization method does.
How Does It Work?
Free-float capitalization is also known as float-adjusted capitalization. The free-float approach, according to some experts, is a superior means of estimating market capitalization (as opposed to the full-market capitalization method, for example).
A company’s full market capitalization comprises all of the shares issued under its stock issuance plan. Through stock option compensation arrangements, companies often issue unexercised shares to insiders. Promoters and governments are examples of non-exercising stockholders. Because corporations have varying degrees of strategic plans in place for granting stock options and exercisable shares, full market capitalization weighting for indexes is seldom applied and would drastically modify the return dynamic of an index.
The free-float approach is claimed to offer a more accurate depiction of market movements and actively traded equities in the market. The market capitalization obtained using a free-float technique is lower than that obtained using a complete market capitalization method. Because it only considers the shares that are available for trading, an index that follows a free-float methodology tends to reflect market developments. It also makes the index more diverse by reducing the concentration of the index’s top few firms.
How to Use the Free-Float Method to Calculate Market Capitalization
The following is how the free-float approach is calculated:
Share Price x (Number of Issued Shares – Locked-In Shares) = FFM
Many of the world’s main indexes have embraced the free-float technique. In addition, there is a link between the free-float technique and volatility. Volatility is inversely proportional to the quantity of free-floating shares in a corporation. Because there are more traders buying and selling the shares, a bigger free float usually suggests the stock’s volatility is lower. Because fewer transactions change the market considerably and there are a limited number of shares available to buy and/or sell, a lower free-float correlates to increased volatility. Most institutional investors favor trading businesses with a bigger free-float since they may purchase and sell a large number of shares without affecting the price significantly.
What is the difference between free float and total market capitalization?
Since shares owned by promoters or those that are locked in are removed, free-float market capitalization is smaller than total market capitalization. Because of the government’s large investment, Coal India has a total market capitalization of Rs 1.8 lakh crore but a free-float market capitalization of roughly Rs 35,600 crore.
What impact does it have on stock trading?
Since fewer transactions are required to affect the share price, stocks with a lower free-float are more likely to experience increased price volatility. Volatility is lower with a higher free float, on the other hand. Because the number of persons buying and selling shares in equities with a big free float is larger, a modest amount of trade has little impact on the price.
What is the role of the free float approach in index calculation?
The free-float market capitalization technique is used by both the NSE and the BSE to generate their benchmark indexes, the Nifty and the Sensex, and allocate weight to firms in the index. As a result, a corporation with a bigger free float is given more weight in the indexes. Because it only considers shares that are available for trade, a free-float index better captures market developments. It also helps to broaden the index by reducing the concentration of the top few firms.
Market Capitalization – Weighted vs Price Weighted
Price or market capitalization are generally used to weight market indexes. Both techniques use different weighting types to weigh the performance of the indexes’ component stocks. The most prevalent index-weighting mechanism is market capitalization weighting.
The technique of weighing utilized by an index has a substantial impact on the index’s total performance. Price-weighted indexes construct an index’s returns by dividing the index’s constituent stock returns by their price levels. Stocks having a higher price get a larger weighting in a price-weighted index, and hence have a greater effect on the index’s performance (regardless of their market capitalizations). Due to differences in index methodology, price-weighted and capitalization-weighted indexes differ significantly.
Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.