DEFINITION of 'Float Shrink'
A reduction in the number of a publicly traded company’s shares available for trading. Float shrink can occur in a number of ways – through a buyback or repurchase of a company’s shares, an investor acquiring a large stake in a company or even through a reverse split or share consolidation. The term “float shrink,” however, is most commonly associated with share buybacks, since this is a popular way for companies to return cash to their shareholders. A float shrink achieved through a share buyback also reduces the number of total shares outstanding for a company, which has a positive impact on earnings per share and cash flow per share.
BREAKING DOWN 'Float Shrink'
Share buybacks and dividend payments are favored avenues for companies to reward their shareholders, but the two are not mutually exclusive, and most successful companies try to reward their shareholders through consistent dividend increases and regular share buybacks.
As an example of how float shrink can impact EPS, consider a company that has 50 million shares outstanding, with a float of 35 million shares. The shares are trading at $15, for a market capitalization of $750 million. The company reports net income of $50 million in a given year – call it Year 1 – for EPS of $1. In the following year (Year 2), it buys back 5 million of its shares on the open market. This buyback amounts to 10% of its total outstanding shares, or 14.3% of float (i.e. 5 million/35 million), and as a result, it now has 45 million shares outstanding at the end of Year 2.
Assume the company achieves net income of $55 million in Year 2. While net income has increased 10%, because of the share buyback, EPS is now at $1.22 (i.e. $55 million/45 million), an increase of 22%.
Recall that shares were trading at $15 at the end of Year 1, for a Price-Earnings (P/E) multiple of 15. Assuming that the P/E multiple is unchanged at the end of Year 2, the shares should be trading at $18.30 (i.e. P/E of 15 x EPS of $1.22).
Float shrink through share buybacks can boost the performance of investment portfolios, as companies with consistent buybacks may outperform the broad market index over long periods of time. For example, in the ten years ending November 2013, the S&P Buyback Index was up 158%, outperforming the S&P 500 by 90 percentage points. This outperformance has led to renewed investor focus on float shrink and the introduction of a few float shrink exchange-traded funds (ETFs).
Note that while float shrink can also be achieved through a strategic investor’s acquisition of a large stake in a company, this does not have the same positive impact as a buyback, because the total number of shares outstanding remains the same.