Browse
Log in / Register
Share
A conversion ratio (CR) is the number of common shares an investor receives upon converting a single bond or preferred share. Understanding this key financial metric is crucial for investors evaluating convertible securities, as it directly impacts the potential profitability of the conversion decision. The ratio is set by the issuing company and is calculated using a simple formula.
The conversion ratio is a predetermined figure defined in the terms of a convertible security, such as a convertible bond or convertible preferred stock. These securities are unique because they can be exchanged, or converted, into a set number of common shares of the issuing company after a specified period. The CR answers a fundamental question for an investor: "If I convert my security, how many shares will I get?"
The decision to convert is typically driven by the market performance of the underlying common stock. Initially, the conversion price—the effective price paid per common share upon conversion—is set higher than the stock's current market price. Conversion becomes attractive only if the market price rises to meet or exceed this conversion price. Convertible securities often have lower yields than their non-convertible counterparts, with the conversion feature acting as a compensating benefit for the investor.
The conversion ratio is calculated using a straightforward formula. The process involves identifying two key values from the security's agreement.
Conversion Ratio Formula:
Conversion Ratio = Par Value of Convertible Security / Conversion Price of Equity
1. Identify the Par Value The par value (also known as face value or nominal value) is the security's original issuance price. For a convertible bond, this is typically a round figure like $1,000. It's important to distinguish par value from market value, which is the price the security trades for on the secondary market.
2. Determine the Conversion Price The conversion price is the price per common share at which the conversion takes place. This value is fixed when the security is issued and is explicitly stated in the offering documents.
3. Apply the Formula Dividing the par value by the conversion price gives you the CR. For example:
This result means one bond can be converted into 20 shares of common stock.
A conversion premium represents the additional cost an investor effectively pays for the conversion option. It arises because the conversion price is initially set above the common stock's market price. Furthermore, if the market value of the convertible bond itself rises above its par value, a buyer on the secondary market pays a premium for the bond relative to the value of the underlying shares.
For instance, if a convertible bond with a par value of $1,000 (convertible into 50 shares at $20 each) is trading on the market for $1,100, the conversion premium is $100. This means an investor is paying $100 extra for the right to convert.
Example 1: Convertible Bond An investor purchases a convertible bond with a $2,000 par value. The agreement states a conversion ratio of 40.
Example 2: Convertible Preferred Stock An investor buys 200 shares of convertible preferred stock at $50 per share. Each share has a conversion ratio of 4.
| Security Type | Par Value | Conversion Price | Conversion Ratio | Common Shares Received |
|---|---|---|---|---|
| Convertible Bond | $1,000 | $50 | 20 | 20 |
| Convertible Bond | $2,000 | $50 | 40 | 40 |
| Pref. Share (per share) | $50 | $12.50 | 4 | 4 |
What is the difference between common stock and preferred stock? The primary differences lie in shareholder rights. Preferred stock generally does not carry voting rights but has a higher claim on dividends and assets in liquidation. Common stock usually provides voting rights (one vote per share) but has a lower priority for dividends and assets.
Why do companies issue convertible securities? Companies issue them to raise capital at a lower cost. Because convertible securities offer investors the potential for future equity appreciation, companies can offer lower coupon rates on bonds or lower dividend yields on preferred shares compared to non-convertible alternatives.
Can a company force an investor to convert? Yes, based on our assessment of common agreements, some convertible securities include a call feature. This allows the issuing company to force conversion, typically if the common stock price has risen significantly above the conversion price, allowing the company to eliminate its obligation to pay interest or dividends.
In summary, the key points for any investor to remember are:
