What is Free Float? (Beginners Guide)

When you delve into the world of stock trading and investing, you’ll often come across various technical terms and concepts that may seem complex at first. One such term is “free float.” Understanding free float is essential for anyone looking to make informed investment decisions, as it provides insights into the liquidity, volatility, and overall accessibility of a company’s stock. This comprehensive guide will break down what free float is, why it matters, and how it impacts the stock market.

Definition of Free Float

Free float refers to the number of a company’s shares that are available for trading by the general public. These shares are not held by insiders, such as company executives, directors, or large institutional investors who may have restrictions on selling their shares. In simple terms, free float represents the portion of a company’s total outstanding shares that are “floating” freely in the market and can be bought or sold without any restrictions.

Free Float vs. Outstanding Shares

To fully grasp the concept of free float, it’s important to distinguish it from the total number of outstanding shares.

• Outstanding Shares: This refers to the total number of shares that a company has issued and that are currently held by all shareholders, including insiders, institutions, and the public.
• Free Float: This is a subset of the outstanding shares and excludes shares that are held by insiders, strategic investors, or those that are subject to lock-up periods.

For example, if a company has 10 million outstanding shares and 3 million of those shares are held by insiders or locked up, then the free float would be 7 million shares.

Why is Free Float Important?

Free float is a critical metric for several reasons:

Liquidity

• Higher Free Float = Greater Liquidity: A higher free float means more shares are available for trading, which generally leads to greater liquidity in the market. Liquidity is important because it makes it easier for investors to buy or sell shares without causing a significant impact on the stock price.
• Lower Free Float = Lower Liquidity: Conversely, a low free float can lead to lower liquidity, meaning there are fewer shares available for trading. This can result in wider bid-ask spreads (the difference between the buying and selling price) and greater price volatility.

Price Volatility

Impact on Stock Volatility: Stocks with a low free float are typically more volatile than those with a higher free float. This is because any significant buying or selling activity can lead to sharp price movements.

For example, if a stock has a low free float and a large investor decides to buy a substantial amount of shares, the limited supply could drive the price up rapidly. Similarly, if a large holder sells, the price could drop significantly.

Market Capitalization

• Influence on Market Cap Calculations: Free float is used in the calculation of a company’s market capitalization for certain indexes, such as the FTSE 100 or S&P 500. Market capitalization represents the total market value of a company’s outstanding shares and is a key indicator of its size and importance in the market.
• Index Inclusion: Many stock market indexes use free float-adjusted market capitalization to determine the weighting of each stock within the index. This means that companies with a higher free float may have a larger impact on the index’s performance.

Investor Sentiment

Perception of Accessibility: A higher free float can be perceived positively by investors as it suggests that the company’s shares are more accessible and that there is less insider control over the stock. On the other hand, a low free float might indicate that the stock is tightly held and could be more susceptible to manipulation or sudden price changes.

Factors That Influence Free Float

Several factors can influence a company’s free float:

• Insider Holdings: Ownership by Executives and Founders: If a significant portion of a company’s shares is held by its founders, executives, or other insiders, the free float will be lower. These shares are often subject to restrictions that prevent them from being sold immediately, reducing the number of shares available to the public.
• Institutional Holdings: Large Institutional Investors: When large institutional investors, such as mutual funds or pension funds, hold a significant portion of a company’s shares, it can also reduce the free float. However, these institutions may trade shares more frequently than insiders, potentially increasing liquidity.
• Lock-Up Periods: Restrictions on Selling Shares: After an initial public offering (IPO), there is often a lock-up period during which insiders and early investors are prohibited from selling their shares. This lock-up period can last several months and temporarily reduces the free float until it expires.
• Stock Buybacks: Company Repurchases: When a company buys back its shares from the market, it reduces the number of outstanding shares, which can also impact the free float. If the repurchased shares are retired or held as treasury shares, they are no longer part of the free float.
• Secondary Offerings: Issuing New Shares: If a company issues new shares through a secondary offering, it can increase the free float by making more shares available to the public. This can lead to greater liquidity and potentially lower volatility.

Calculating Free Float

The free float of a company can be calculated using the following formula:
\[\text{Free Float} = \text{Total Outstanding Shares} – \text{Shares Held by Insiders and Restricted Shares}\]

For example, if a company has 50 million outstanding shares and 10 million of those are held by insiders or are restricted, the free float would be:
\[50 \text{ million} – 10 \text{ million} = 40 \text{ million}\]

This means that 40 million shares are available for trading in the market.

Real-World Examples of Free Float

Understanding free float becomes more tangible when looking at real-world examples:

• High Free Float Companies: Apple Inc. (AAPL): Apple has a high free float, with the majority of its shares available for public trading. This contributes to the stock’s high liquidity and relatively lower volatility compared to smaller companies.
• Low Free Float Companies: Snap Inc. (SNAP): When Snap Inc. went public, it had a relatively low free float because a significant portion of its shares was held by its founders and early investors. This led to higher volatility in its stock price, especially in the early days of trading.

The Impact of Free Float on Investment Strategies

For investors, understanding free float can play a crucial role in shaping investment strategies:

• Long-Term Investing- Stability vs. Growth Potential: Investors seeking stable, long-term growth might prefer companies with a higher free float, as these stocks tend to have lower volatility and greater liquidity.
• Short-Term Trading – Opportunities in Volatility: Traders who engage in short-term trading may find opportunities in stocks with a low free float due to their higher volatility. However, this approach carries greater risk and requires careful market analysis.
• Index Fund Investing –  Influence on Index Composition: For those investing in index funds, understanding how free float affects index weighting can be important. Stocks with a higher free float may have a larger impact on the fund’s performance, influencing the overall returns.

Conclusion

Free float is a fundamental concept in stock trading and investing that provides insights into a company’s stock liquidity, volatility, and market dynamics. By understanding free float, investors can make more informed decisions about which stocks to buy or sell and how to manage their portfolios effectively. Whether you are a long-term investor or a short-term trader, keeping an eye on a company’s free float can help you navigate the complexities of the stock market with greater confidence.