Free-Float Methodology

What Is Free-Float Methodology?

The free-float methodology is a method of calculating the market capitalization of a stock market index's underlying companies. With the 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.

Rather than using all of the shares (both active and inactive shares), as is the case with the full-market capitalization method, the free-float method excludes locked-in shares, such as those held by insiders, promoters, and governments.

Understanding Free-Float Methodology

The free-float methodology is sometimes referred to as float-adjusted capitalization. According to some experts, the free-float method is considered to be a better way of calculating market capitalization (as opposed to the full-market capitalization method, for example).

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 because companies have various levels of strategic plans in place for issuing stock options and exercisable shares.

The free-float methodology is usually thought to provide 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.

An index that uses a free-float methodology tends to reflect market trends because it only takes into consideration the shares that are available for trade. It also makes the index more broad-based because it lessens the concentration of the top few companies in the index. 

How to Calculate Market Capitalization Using the Free-Float Method

Free-float methodology is calculated as follows:

FFM = Share Price x (Number of Shares Issued – Locked-In Shares)

The free-float methodology has been adopted by many of the world's major indexes. It is used by the S&P 500 Index, by Morgan Stanley Capital International (MSCI) World Index, and by the Financial Times Stock Exchange Group (FTSE) 100 Index.

There is also a relationship between free-float methodology and volatility. The number of free-floating shares of a company is inversely correlated to 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 higher 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 impact on the price.

Price-Weighted vs. Market-Capitalization-Weighted

Indexes in the market are usually weighted by either price or market capitalization. Both methodologies weigh the returns of the indexes’ individual stocks by their respective weighting types. Market capitalization weighting is the most common index-weighting methodology. The leading capitalization-weighted index in the United States is the S&P 500 Index.

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 indexes 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 an example of one of the few price-weighted indexes in the market.

Example of Free-Float Methodology

Suppose that stock ABC is trading at $100 and has 125,000 shares in total. Out of this amount, 25,000 shares are locked-in (meaning that they are held by large institutional investors and company management and are not available for trading). Using the free-float methodology, ABC's market capitalization is 100 x 100,000 (total number of shares available for trading) = $10 million.