What is a floating methodology?
A floating methodology is a method by which the market capitalization of the companies underlying an index is calculated. The float market capitalization is calculated by taking the share price and multiplying it by the number of shares readily available on the market. Instead of using all active and inactive stocks, as with the total market capitalization method, the free float method excludes locked-in stocks such as those held by insiders, promoters and governments.
Understanding the floating methodology
Floating capitalization can also be called float-adjusted capitalization. The float method is considered a better way to calculate market capitalization, as it provides a more accurate picture of market movements and the stocks actively available for trading on the market. When using a floating methodology, the resulting market capitalization is less than that which would result from a full market capitalization method.
The float methodology has been adopted by most of the main world indices. It is widely used by Standard and Poor’s, MSCI and FTSE.
Calculation of the floating methodology
The float methodology is calculated as follows:
FFM = share price x (number of shares issued – immobilized shares)
Market indices are often weighted by price or market capitalization. Both methodologies weight the returns of individual stocks in the indices by their respective weighting types.
The full market capitalization includes all the shares provided by a company as part of its share issue plan. Companies often issue unexercised shares to insiders through stock option compensation plans. Other holders of unexercised shares may include promoters and governments. Full weighting of the market capitalization of indices is seldom used and would significantly change the performance dynamics of an index, as companies have different levels of strategic plans for issuing exercisable stock options and stocks.
Weighting by capitalization is the most common method of weighting the index. The US capitalization-weighted index is the S&P 500 Index. Other capitalization-weighted indices include the MSCI World Index and the FTSE 100 Index.
Weighted indices based on capitalization and prices
The type of weighting methodology used by an index significantly affects the overall returns of the index. Price-weighted indices calculate the returns of an index by weighting the individual stock market returns of the index by their price level. In a price-weighted index, the higher-priced stocks receive a higher weighting and therefore have more influence on the returns of the index, regardless of their market capitalization. Price-weighted indices relative to capitalization vary considerably due to their index methodology.
On the stock market, very few indices are weighted according to prices. The Dow Jones Industrial Average (DJIA) is an excellent example of one of the few market price-weighted indices.
How does the float method affect trading?
A floating methodology tends to rationally reflect market trends as it only considers stocks available for trading and makes the index wider as it decreases the concentration of the few most important companies in the index.
There is also the relationship between free float and volatility. In general, a larger float means that the security’s volatility was lower since there are more traders buying and selling the stocks. This means that a smaller float equals more volatility, as fewer transactions lower the price significantly and there are a limited number of stocks available to buy and / or sell. Most institutional investors prefer trading companies with a larger free float because they can buy or sell a large number of shares without having a big impact on the price.
Key points to remember
- A floating methodology is used to calculate a company’s market capitalization by dividing its share price by the number of shares readily available on the market.
- It is inversely correlated with volatility. A larger float generally means that the volatility of the stock is lower, and a smaller float generally means greater volatility.
Example of floating methodology
Suppose the ABC share is trading at $ 100 and has 125,000 shares in total. Of this amount, 25,000 shares are immobilized, which means that they are held by large institutional investors and the management of the company and are not available for trading. Next, ABC’s market capitalization using the float method is 100 X 100,000 (total number of shares available for trading) = $ 10 million.