A conversion value is the price at which a convertible security is converted into common stock. There are two main types of securities which companies use to raise capital: bonds and stocks. Bonds offer investors a fixed income stream over the life of the bond, whereas stocks offer investors the opportunity to share in the profits of the business through share price appreciation and dividends. Both securities have pros and cons. As a result, bankers and companies issue hybrid securities with characteristics of both. One type of hybrid security allows investors to convert from owning company bonds to owning company stock. These types of securities are referred to as convertible securities. When the company converts bonds to stock, that sale price is the conversion value, which is determined when the security is originally issued.
Risk-adverse investors like the ability to invest in a company through debt which is considered to have less risk than stock. Convertible preferred shares or convertible bonds command a higher premium or price in the market because of this option. Investors are able to participate in share price appreciation without the risk of losing the principal amount invested in the security.
Many companies issue both preferred stock and common stock. Both represent some form of ownership, but only common shareholders can vote. Additionally, common shareholders benefit from share price appreciation, whereas preferred shareholders generally have a fixed payment every six months, like a bond. As such, prospectus statements will have a certain price at which the preferred shares are eligible to be converted into common shares. The same principal holds for convertible bonds.
Knowing what the conversion value means is one thing. Understanding where to find it and how to use it, however, is another. Investors can find the conversion value in the bond indenture for convertible bonds or in the prospectus for convertible preferred stock. Practically speaking, the conversion value tells the investor or financial adviser how many shares will be received after conversion. In addition, it may be necessary to compute the conversion value from a conversion ratio.
As an example, if investors own preferred shares that are priced at $100 US Dollars (USD) and the prospectus says the conversion ratio is five, this means that the investor is allowed to trade in one preferred share for five common shares of stock. Dividing the current price of the preferred shares by the conversion ratio gives the price at which the common stock must be sold at in order for the investor to make a profit from the conversion. For instance, $100/5 = $20.00 USD. This is known as the market conversion value since it is unlikely that an investor will trade at a price lower than this in order to make a profit.
