What is a Free-Float Methodology
A 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 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.
Calculating Free-Float Methodology
Free-float methodology is calculated as follows:
FFM = Share Price x (Number of Shares Issued – Locked-In Shares)
Capitalization Weighted Indexes
Indexes in the market are often weighted by either price or capitalization. Both methodologies weigh 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 weighing 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 (DJIA) is a leading example of one of the few price weighted indexes in the market.
How Does the Free-Float Method Affect Trading?
A free-float methodology tends to rationally reflect market trends because it only takes into consideration the shares that are available for trade and it makes the index more broad-based because it lessens the concentration of the top few companies in the index.
There is also the relationship between the free-float and volatility. Typically, a larger free-float means that the stock’s volatility was lower because there are more traders buying and selling the shares. That means that a smaller free-float equates to more volatility, since fewer trades move the price significantly and there are a limited amount of shares available to be bought and/or sold. Most institutional investors prefer trading companies with a larger free-float because they can buy or sell a big number of shares without having a big affect on the price.