There are plenty of indicators and multipliers for analysing public companies. In this article, we’ll talk about one of them, the Free float ratio. We’ll find out the formula for calculating it and describe how investors use it when analysing the market situation.
The Free float ratio is the quantity of shares available for public trading. They are traded on stock exchanges, are not owned by strategic investors, and are available to retail ones. You can meet other names it goes by – Float or Public Float.
What shares are not included in a Free float calculation?
When calculating the Free float ratio, the following shares are not included:
- Owned by shareholders, the company’s management and top managers
- Owned by the state
- Owned by big investment funds, which are majority shareholders
In addition, limited shares are also not taken into account. For example, shares that were given to an employee as a reward for the merits for a company.
To calculate the Free float ratio, we need to know the number of free float shares and the total number of shares issued. To make the formula look easy to understand, we’ll denote these parameters as A and B, respectively.
The Free float ratio calculation formula:
Free float = A / B
The ratio can be specified in two formats – in percentage (for example, 50%) or decimal fraction (for example, 0.5).
Let’s say that a company issued 100,000 shares; 51% of them, 51,000, a majority stake, are owned by the management, while the rest 49,000 shares were released for free circulation. In this case, the Free float ratio will be 0.49 or 49%.
The Free float calculation: 49,000 / 100,000 = 0.49
- A split is a stock split with a fixed split ratio. Through splits, companies increase the number of shares and reduce their price. For example, a company had 100 shares at $4 per share, and after a 1:2 split they own 200 shares at $2
- Issue of securities is a way to increase share capital and attract investments
- Share sales by major shareholders – shares that were frozen before are released for free circulation. There might be different reasons for this
- A buyback is the re-acquisition by a company of its own shares. Having amassed enough available funds, a company repurchases its shares from its shareholders and retires them. As a result, the share of major investors increases, as well as their influence on a company
- Buyout of floating securities by major shareholders to get a majority stake
- Consolidation of shares (reverse split) is a conversion of two or more shares into one of the same categories
The optimal Free float value for both traders and investors is in the range of 40–80%. Such volumes of free float shares provide some kind of protection against market fluctuations, increase the instrument’s liquidity, and afford an opportunity to buy or sell an asset at any time. In other words, the higher the Free float ratio, the more liquid the instrument is and the more opportunities investors have.
First of all, small or limited market demand. After buying some shares, a trader might find it difficult to sell them. There is a possibility that there won’t be a buyer in the market to acquire this asset, or its price might be very low.
Secondly, there might be sharp price fluctuations in either direction at a time of news releases, which may cause panic among market players.
Thirdly, buying a vast amount of shares by a single investor might significantly raise the price and cause disbalance. Selling a major minority shareholding can be delayed and it also might result in a price surge. In some cases, shares can’t be sold at all because there are no investors willing to buy them.
To begin with, the ratio provides an investor with an understanding of an instrument’s liquidity. If the ratio value is 40–80%, an instrument is considered quite liquid and involves smaller trading-related risks.
The Free float value above 80% means that it will be difficult for jobbers and big-time investors to cause higher volatility in the market by selling/buying big amounts of shares.
A ratio value below 40% says that the majority of shares are owned by principal shareholders and they have the ability to influence share prices by unloading a lot of shares in the market. Small amounts of free float shares raise additional difficulties for selling them.
Combined with other indicators and multipliers, the Free float ratio offers traders and investors an opportunity to choose a more suitable instrument in terms of liquidity and fair market price.
Experience has proven that there is no direct correlation between liquidity and Free float, but there is an opinion that the high ratio value gives a slight edge over the low one.
Image and article originally from blog.roboforex.com. Read the original article here.