Adjusted average market cap

What Is Adjusted Average Market Cap?

Adjusted average market capitalization is a specific calculation of a company's market capitalization that typically accounts for the portion of shares readily available for trading in the public market, often referred to as its free float. This adjustment excludes restricted shares, such as those held by company insiders, governments, or strategic investors, providing a more accurate representation of the market value accessible to general investors. Within investment analysis, this metric is crucial for the construction and maintenance of various stock market index products, as it reflects the true liquidity and investability of a company's equities. An adjusted average market cap helps index providers and investors understand the real-world impact of a stock's price movements on an index's performance.

History and Origin

The concept of adjusting market capitalization gained prominence as global equity markets evolved and became more interconnected. Historically, indexes were often constructed using full market capitalization, meaning all outstanding shares were considered when determining a company's weight. However, this approach presented a distorted view of market accessibility, as a significant portion of shares might be locked up and not available for public trading.

Major index providers began adopting free-float methodologies in the late 1990s and early 2000s to address this issue. For instance, S&P Dow Jones Indices, a prominent global index provider, emphasizes that its market-capitalization-weighted indices are "float-adjusted" to ensure that calculations only include shares available to investors, excluding closely held shares.¹⁴ Similarly, MSCI, another leading index firm, transitioned to a Global Investable Market Indexes methodology, completed by May 2008, which includes specific rules for determining the "free float-adjustment factor" and minimum free float market capitalization requirements for security inclusion.¹², ¹³ This shift reflected a growing industry consensus that indexes should represent what is genuinely investable, leading to a more accurate reflection of market movements for portfolio management and investment products.

Key Takeaways

• Adjusted average market cap filters out shares not readily available for public trading, such as those held by insiders or governments.
• It is a fundamental input for major index providers (e.g., S&P Dow Jones, MSCI, FTSE Russell) in their index construction methodologies.
• This metric provides a more realistic representation of a company's investable market value and liquidity.
• Adjusted average market cap is crucial for the accuracy of a benchmark and the integrity of index-linked financial products.
• It influences the weighting of securities within an index, thereby impacting overall index performance and investor exposure.

Formula and Calculation

The calculation of adjusted average market cap begins with the total shares outstanding, which is then refined by applying a free-float factor. The "average" aspect typically refers to an average over a specified period (e.g., daily, monthly, or quarterly average) or an average of fundamental factors used in alternative index constructions.

The basic formula for a company's float-adjusted market capitalization is:

$\text{Float-Adjusted Market Cap} = \text{Share Price} \times \text{Number of Free-Float Shares}$

Here, the "Number of Free-Float Shares" represents the total shares outstanding minus restricted shares. For an "Adjusted Average Market Cap," this calculation would typically be performed for a series of periods, and then averaged. For example, to calculate a simple average over 'n' periods:

$\text{Adjusted Average Market Cap} = \frac{\sum_{i=1}^{n} (\text{Share Price}_i \times \text{Free-Float Shares}_i)}{n}$

In index construction, this float-adjusted market capitalization is then used to determine a company's weighting. For instance, S&P Dow Jones Indices calculates the index market value by summing the product of price, shares, investable weight factor (IWF), and exchange rate for each security. The IWF is essentially the free-float factor.¹¹ The divisor of the index is adjusted to ensure that changes in share count or IWF do not artificially change the index level.¹⁰

Alternative methodologies, such as those employed by the FTSE RAFI® Index Series developed by Research Affiliates, use fundamental measures of company size like sales, cash flow, dividend, and book value to determine constituent weights, moving away from price-based market capitalization. ⁸, ⁹While not strictly "adjusted average market cap" in the float-adjusted sense, these represent alternative "adjustments" to traditional market capitalization weighting based on economic fundamentals.

Interpreting the Adjusted Average Market Cap

Interpreting the adjusted average market cap involves understanding its implications for an index's representation and an investor's exposure. A higher adjusted average market cap for a given company within an index indicates that the company holds a significant weight due to a large number of publicly tradable shares, rather than just a high share price or large total outstanding shares. This implies greater influence on the index's performance and potentially higher liquidity for investors trading the underlying securities or index-tracking products.

This metric is particularly relevant in the context of passive investing strategies that aim to replicate the performance of a market index. The adjusted average market cap ensures that the index accurately reflects the investable opportunity set, preventing overconcentration in companies where a substantial portion of shares is not freely traded. Index providers such as FTSE Russell define minimum investable market capitalization inclusion thresholds for securities to be eligible for their global equity index series, ensuring investability.
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Hypothetical Example

Consider two hypothetical companies, Alpha Corp and Beta Inc., both with a current share price of $100.

Alpha Corp:

• Total shares outstanding: 100 million
• Shares held by insiders/government (restricted): 40 million
• Free-float shares: 100 million - 40 million = 60 million
• Float-adjusted market cap: $100 * 60 million = $6 billion

Beta Inc.:

• Total shares outstanding: 80 million
• Shares held by insiders/government (restricted): 5 million
• Free-float shares: 80 million - 5 million = 75 million
• Float-adjusted market cap: $100 * 75 million = $7.5 billion

Even though Alpha Corp has more total shares outstanding, its adjusted market cap is lower than Beta Inc.'s because a larger proportion of its shares are restricted. If an index were constructed using full market capitalization, Alpha Corp's total market cap would be $10 billion ($100 * 100 million), making it appear larger than Beta Inc. ($8 billion). However, using the float-adjusted market cap, Beta Inc. would have a larger weight in a free-float-weighted index, accurately reflecting its greater availability to public investors.

Now, if an "adjusted average market cap" were used, the float-adjusted market cap for each company would be calculated at regular intervals (e.g., daily) over a period, and then averaged. For instance, if over a month, Alpha Corp's daily float-adjusted market cap averaged $5.8 billion and Beta Inc.'s averaged $7.3 billion, these average values would then be used for index weighting decisions at the end of that period. This averaging helps smooth out short-term price fluctuations and provides a more stable representation of a company's investable size over time, which is beneficial for diversification within index funds.

Practical Applications

Adjusted average market cap is a critical concept in several areas of finance:

• Index Construction and Maintenance: This is its primary application. Major index providers like S&P Dow Jones, MSCI, and FTSE Russell employ float adjustment methodologies to ensure their indices accurately reflect the investable universe of equities. This ensures that index-tracking products, such as exchange-traded funds (ETFs) and index mutual funds, provide investors with exposure to shares genuinely available for trading. MSCI's methodology, for example, includes a "Minimum Free Float Market Capitalization Requirement" to determine eligibility for inclusion in its global indexes.
  ⁶* Portfolio Management and Investment Strategy: Fund managers, especially those engaged in passive investing or quantitative investment strategy, rely on adjusted market cap data to size their positions and maintain adherence to their chosen benchmarks. It helps in assessing the true liquidity of a stock and the potential impact of large trades.
• Market Analysis: Analysts use adjusted market cap to categorize companies into size segments (e.g., large-cap, mid-cap, small-cap) more realistically. This segmentation informs investment decisions and helps in comparing companies of similar actual investable sizes.
• Regulatory Reporting and Compliance: In some cases, regulatory bodies or investment guidelines may reference market capitalization, and the adjusted figure provides a more relevant basis for such reporting, ensuring fair and transparent market practices. The rules and methodologies of index providers are often publicly available, reflecting a commitment to transparency in financial markets.
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Limitations and Criticisms

While adjusted average market cap offers a more accurate view of market liquidity than full market capitalization, it is not without limitations:

• Subjectivity in Free-Float Determination: The exact definition and calculation of "free-float shares" can vary slightly among index providers. What one provider deems restricted, another might partially include. This can lead to minor discrepancies in how the adjusted market cap is calculated for the same company across different indexes.
• Lag in Updates: The calculation of adjusted average market cap often relies on publicly available filings and ownership disclosures, which may not be real-time. This can introduce a lag, meaning the calculated free float might not perfectly reflect instantaneous changes in ownership structures, although major index providers typically conduct quarterly reviews to update share counts and free-float factors.
  ⁴* Does Not Account for Liquidity Beyond Float: While free float generally correlates with liquidity, it does not guarantee high trading volume or ease of execution for large orders. A company with a high free float might still have low daily trading activity, impacting a portfolio manager's ability to trade its securities efficiently.
• Impact of Corporate Actions: Significant corporate actions, such as secondary offerings, share buybacks, or mergers, can alter the free float and thus the adjusted market cap. While index providers adjust for these, there can be temporary impacts or rebalancing challenges.

Adjusted Average Market Cap vs. Full Market Capitalization

The primary distinction between adjusted average market cap and full market capitalization lies in the shares considered for the calculation.

Confusion often arises because "market capitalization" is sometimes used broadly when "full market capitalization" is implied. However, in modern index construction and investment strategy, the distinction is critical. Adjusted average market cap provides a more practical and realistic measure for understanding a company's size within a tradable market context.

FAQs

Why is an adjusted average market cap used in indexes?

It is used to ensure that the index accurately reflects the portion of a company's shares that are actually available for public trading. This makes the index more investable and prevents it from being skewed by shares that are locked up and cannot be bought or sold easily.

What types of shares are typically excluded from the free float calculation?

Shares commonly excluded from the free float calculation include those held by strategic investors, governments, company founders, board members, employees (if restricted from trading), and shares subject to lock-up agreements.

Does adjusted average market cap affect an index's performance?

Yes, it significantly affects an index's performance because it determines the weight of each company within the index. Companies with a larger adjusted average market cap will have a greater influence on the index's overall movements. This ensures the index reflects the performance of the investable market more closely.

How often is the adjusted average market cap updated for index purposes?

Index providers typically review and update the free-float factors and shares outstanding on a regular basis, often quarterly or semi-annually. This ensures the adjusted average market cap used for index calculations remains current.

#², ³## Is adjusted average market cap the same as a fundamental index?
No, adjusted average market cap (specifically float-adjusted) is a refinement of market capitalization weighting. A fundamental index is a different type of investment strategy that weights companies based on fundamental measures like sales, dividends, and cash flow rather than their market price or capitalization. While both aim for a more effective representation of company size or value, their methodologies diverge significantly.¹