What to Do
If conversion price is set when the security is issued, it will be defined in a legal agreement between the issuing company and the investor. If not, then a “conversion ratio” is used to determine the number of shares that can be exchanged for the security—which in turn determines the price.
Example:
Suppose the conversion ratio for a security is 40:1. This means that for every $1,000 of security exchanged for stock, the investor gets 40 common or ordinary shares. To work out conversion price, simply divide $1,000 by 40:
Investors can compare conversion price with current market price to establish a “conversion value,” and clarify the best way forward. If shares are trading at $32 on the open market, the conversion value of each $1,000 security is 32 × 40 = $1,280, so conversion looks attractive. But if the market price is $21 per share, the conversion value is only $840 (21 × 40), and the investor would do better to wait.
If the conversion price is known but not the ratio, the latter can be calculated by dividing the par value of the security (typically $1,000) by the price. So using our example:
What You Need to Know
- Depending on the terms of the agreement, conversion ratios may fluctuate (occasionally there is specific provision dealing with this), which protects the value of existing stock and prevents disadvantage to other investors.
- A conversion ratio set at the time of issue usually protects against any dilution if stock is split, but not if there is a new issue of common stock.
- The price of convertible bonds often follows that of a company’s stock very closely—indeed, they may be virtually the same.
- “Forced conversion” happens when the issuer calls in the security. Usually this happens when the underlying stock price is high, so investors need to monitor changes carefully.
- In case of a merger, conversion ratio determines how many shares of one common stock are issued for each outstanding share of another.
Where to Learn More
Web Site:
investopedia.com: www.investopedia.com
