It is a widely believed notion that free float market cap is a more accurate measure of a company's market value compared to total market capitalisation. That’s because ‘free float’ excludes all shares unavailable for trading.
Let us understand how the free float market cap helps market investors:
- It provides a more accurate representation of the tradeable shares, which investors can freely buy and sell.
- It offers a better assessment of the liquidity of a company's stock.
- It is seen as a more reliable measure of a company's market value.
- It provides a clearer understanding of the company’s market valuation.
Why should investors prefer high free float market cap stocks?
As a rule of thumb, stocks with higher free float market capitalisation are generally more liquid. This means there is a greater volume of shares available for trading. The abundance of tradeable shares often leads to:
- Narrower bid-ask spreads
and
- Easier execution of trades
Let us understand this in detail:
Narrower bid-ask spreads
|
Easier execution of trades
|
- Bid-ask spreads refer to the difference between:
- The highest price that a buyer is willing to pay (bid)
and
- The lowest price that a seller is willing to accept (ask)
- In stocks with higher free float market cap, there is increased:
- Trading activity
and
- Availability of shares
- This abundance typically leads to narrower bid-ask spreads, which ultimately reduces the transaction costs.
|
|
Furthermore, in stocks with higher free-float market capitalisation, individual trades represent a smaller proportion of the total outstanding shares. As a result, the impact of each trade on the stock price is relatively smaller compared to stocks with lower free float.
Let us understand this better through a hypothetical example:
The scenario
- Say there are two companies: Company A and Company B
- Company A has a larger free float market cap compared to Company B
Consider the following financial data:
Parameters
|
Company A
|
Company B
|
Total shares outstanding (Equity share capital)
|
200 Crore
|
50 Crore
|
Free float shares
|
180 Crore (90% of total shares)
|
10 Crore (20% of total shares)
|
Market price per share
|
Rs. 100
|
Rs. 100
|
The sale of shares of Company A
- Say an investor sells 1 Crore shares of Company A at Rs. 100 per share.
- Since the free float is relatively large (90% of total shares), this trade represents only a small fraction of the total outstanding shares.
- The impact on stock price will be ‘minimal,’ as the trade represents only 0.5% of total outstanding shares.
The sale of shares of Company B
- Again, let us assume an investor sells 1 Crore shares of Company B at Rs. 100 per share.
- Since the free float is relatively small (20% of total shares), this trade represents a larger proportion of the total outstanding shares.
- The impact on stock price will be ‘significant,’ as the trade represents 2% of total outstanding shares.
How is lower free float related to market volatility?
Free float market cap is inversely related to market volatility. This happens because stocks with a lower free float have lower liquidity. In such cases, it takes longer for buyers and sellers to find each other, which results in:
- Wider bid-ask spreads and,
- Higher transaction costs
Lower liquidity leads to rapid price fluctuations and increases volatility as even relatively small trades can have a larger impact on the stock price. Furthermore, stocks with lower free float market cap are often targeted by:
- Speculative traders or
- Investors seeking short-term gains.
This speculative trading activity increases volatility, as it involves rapid buying and selling of shares without significant regard for the underlying fundamentals of the company.
Advantages of using free-float market capitalisation
1. Presents a practical picture
The free-float market capitalisation method evaluates a company’s market value based on the shares actively traded in the market, excluding locked-in shares held by promoters, governments, or other private entities. Unlike the total market capitalisation approach, which includes all shares regardless of their availability, this metric provides a more accurate and actionable representation of a company’s true market position.
2. Avoids distortion in valuation
In some cases, large-cap companies may give the impression that their shares are highly liquid, but most of their stock might be privately held or unavailable for trading. Free-float market capitalisation addresses this issue by focusing on the tradable portion of shares. This enables broader and fairer index construction, reducing over-reliance on a few large-cap companies with limited market float.
3. Relies on a market-driven methodology
Free-float market capitalisation filters out companies with very few publicly available shares, ensuring that the focus remains on businesses with adequate trading liquidity. This method helps investors identify opportunities to invest in companies with sufficient publicly traded shares, allowing them to allocate their funds more effectively.
By concentrating on tradable shares, free-float market capitalisation provides a realistic and balanced framework for evaluating market indices and investment opportunities.
Conclusion
The free float market cap represents the total market value of a company’s outstanding shares that are freely tradeable to the general public. It exclusively ignores the restricted shares, like those held by promoters or certain investors, that are not available for trading. This exclusion provides a clearer picture of the company’s market value.
Also, most investors prefer stocks with a high free float market cap as they are more liquid and have narrower bid-ask spreads.
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