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What is a 'Free-Float Methodology'

Free-float methodology is a method by which the market capitalization of an index's underlying companies is calculated. Free-float methodology market capitalization is calculated by taking the equity's price and multiplying it by the number of shares readily available in the market. Instead of using all of the active and inactive shares, as with the full-market capitalization method, the free-float method excludes locked-in shares such as those held by insiders, promoters and governments.

BREAKING DOWN 'Free-Float Methodology'

Free-float methodology is calculated as follows: FFM = Share Price x (Number of Shares Issued – Locked-In Shares)

Free-float capitalization can also be called float-adjusted capitalization. The free-float method is considered a better way of calculating market capitalization, because it provides a more accurate reflection of market movements and stocks actively available for trading in the market. When using a free-float methodology, the resulting market capitalization is smaller than what would result from a full-market capitalization method.

The free-float methodology has been adopted by most of the world's major indexes. It is widely used by Standard and Poor’s, MSCI and FTSE.

Capitalization Weighted Indexes

Indexes in the market are often either price weighted or capitalization weighted. Both methodologies weight the returns of the indexes’ individual stocks by their respective weighting types.

Full-market capitalization includes all of the shares provided by a company through its stock issuance plan. Companies often issue unexercised stock to insiders through stock option compensation plans. Other holders of unexercised stock can include promoters and governments. Full-market capitalization weighting for indexes is rarely used and would significantly change the return dynamic of an index, as companies have various levels of strategic plans in place for issuing stock options and exercisable shares.

Capitalization weighting is the most common index weighting methodology. The leading capitalization-weighted index in the United States is the S&P 500 Index. Other capitalization-weighted indexes include the MSCI World Index and the FTSE 100 Index.

Capitalization Weighted Versus Price Weighted Indexes

The type of weighting methodology used by an index significantly affects the index’s overall returns. Price-weighted indexes calculate the returns of an index by weighting the individual stock returns of the index by their price levels. In a price-weighted index, stocks with a higher price receive a higher weighting and thus have more influence on the returns of the index, regardless of their market capitalizations. Price-weighted versus capitalization-weighted indexes vary considerably due to their index methodology.

In the trading market, very few indexes are price weighted. The Dow Jones Industrial Average is a leading example of one of the few price-weighted indexes in the market.

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