Convertible securities allow investors to convert from owning corporate bonds to owning corporate shares. The sale price of the converted bonds is the conversion value. Risk-averse investors can invest in convertible preferred stock or bonds to participate in share price appreciation without risking the principal amount invested. The conversion value can be found in the bond contract or prospectus, and can be calculated from the conversion ratio.
A conversion value is the price at which a convertible security is converted into common stock. There are two main types of securities that companies use to raise capital: bonds and stocks. Bonds offer investors a stream of fixed income over the life of the bond, while stocks offer investors the opportunity to share in the profits of the business through share price appreciation and dividends. Both titles have pros and cons. As a result, bankers and corporations issue hybrid securities with characteristics of both. One type of hybrid security allows investors to convert from owning corporate bonds to owning corporate shares. These types of securities are referred to as convertible securities. When the company converts bonds into stock, that sale price is the conversion value, which is determined when the bond was originally issued.
Risk-averse investors love the ability to invest in a company through debt which is considered less risky than stocks. Convertible preferred stock or convertible bonds command a premium or higher market price because of this option. Investors can participate in the share price appreciation without risk of losing the principal amount invested in the stock.
Many companies issue both preferred stock and common stock. Both represent some form of ownership, but only common shareholders can vote. In addition, common stockholders benefit from share price appreciation, while preferred stockholders generally have a fixed payment every six months, such as a bond. Therefore, the prospectus statements will have a certain price at which preferred stock can be converted into common stock. The same principle applies to convertible bonds.
Knowing what conversion value means is one thing. Figuring out where to find it and how to use it, though, is another. Investors can find the conversion value in the bond contract for convertible bonds or in the prospectus for convertible preferred stock. In practice, the conversion value tells the investor or financial advisor how many shares he will receive after the conversion. Additionally, you may need to calculate the conversion value from a conversion ratio.
For example, if investors own preferred stock that is priced at $100 US dollars (USD) and the prospectus says the conversion ratio is five, that means the investor can trade one preferred stock for five common shares. Dividing the current price of preferred stock by the conversion ratio gives the price at which the common stock must be sold for the investor to profit from the conversion. For example, $100/5 = $20.00 USD. This is known as market conversion value as an investor is unlikely to trade below this price to make a profit.
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