The stock market can be intimidating for novice investors, but understanding its components is essential in order to make sound investment decisions. To start, investors need to understand the basics of how stocks are bought and sold.
When a company issues stock, it creates a certain number of shares that represent ownership of the company. These shares can then be bought and sold by investors on the stock market.
Free float is an important factor to consider when evaluating a company’s stock. It is the number of freely-traded shares available in the stock market and is typically lower than the total number of outstanding shares due to restricted shares held by major shareholders.
This article discusses what free float is, how it is calculated, its significance, and how it differs from traditional market capitalization.
What is free float?
A company's market capitalization takes into account all of its outstanding shares. The market does not, however, allow for the unrestricted trading of all existing shares because some are privately owned and cannot be exchanged in public.
A free float in the stock market refers to the number of shares available for trading in the stock market. It is the portion of a company’s shares that are not held by major shareholders, such as government entities, controlling companies, and institutional investors.
In simple words, it is the entire number of outstanding shares of a corporation owned by public investors. This does not include the shares that are locked in by the company's management, investors with a controlling stake, governments, or other private parties.
The concept of the free float was developed to gauge the liquidity of a stock and provide a more accurate representation of its true value.
How to calculate free float?
The Free Float is calculated by subtracting the restricted shares from the total outstanding shares.
Free Float = Total outstanding shares – Restricted shares
Outstanding shares are the number of shares held by a company's shareholders. Restricted shares, on the other hand, are not transferable until certain conditions are met and are typically held by corporate management, such as executives and directors.
What is the significance of free float?
The free float serves as an important indicator of the liquidity of a stock. A high free float indicates a large number of shares that can be bought and sold, which makes it easier for investors to trade in and out of the stock.
On the other hand, a low free float implies that there are fewer shares available for trading and that it may be difficult for investors to buy and sell quickly. In addition, the free float provides a more accurate representation of the value of a stock.
When calculating the market capitalization (market cap) of a company, the number of outstanding shares is used as the denominator. However, if the number of outstanding shares includes a large number of restricted shares, then the market cap will be artificially inflated.
By subtracting the restricted shares from the total number of shares outstanding, the free float serves as a more realistic measure of the company's true market value.
How is free-float market capitalization different from traditional market capitalization?
Let us understand this with an example.
Company X has a total of 100,000 shares with a face value of Rs.50 each. Out of these, 60,000 are publicly traded and the remaining 40,000 are held by promoters, family, trusts, or the government. The total market capitalization of the company is calculated by multiplying the total number of outstanding shares with the stock price which comes to Rs.50 lakh.
However, to calculate the free-float market capitalization of the company, only the number of shares that are publicly traded and available in the market are considered. In this case, it is 60,000 shares and when multiplied by the stock price, the free-float market capitalization of Company B comes to Rs.30 lakh. This means that the total value of the company's freely tradable shares is Rs.30 lakh.
The free-float market capitalization is important for investors as it reflects the true market value of the company, independent of the influence of private holders like promoters, trusts, or the government. Thus, it gives a more accurate picture of the company's performance in the market and helps investors make informed decisions about investing in the company.