What It Measures
Depending on specific terms, the conversion price may be set when the convertible asset is issued.
Why It Is Important
The conversion price is a key factor in an investment strategy. Knowing it helps investors to determine whether or not it is to their advantage to convert their holdings into shares of stock, sell them on the open market, or retain them until they mature or are called by the issuing company.
At the same time, existing stockholders of the issuing company need to know the point at which the value of their shares could be diluted by the creation of additional shares without the concurrent creation of additional capital.
For companies themselves, a conversion price represents an additional financing option: an opportunity to convert debt into equity, an action that itself has advantages and drawbacks.
How It Works in Practice
If the conversion price is set, it will appear in the indenture, a legal agreement between the issuer of a convertible asset and the holder that states specific terms. If the conversion price does not appear in the agreement, a conversion ratio is used to calculate the conversion price.
A conversion ratio of 25:1, for example, means that 25 shares of stock can be obtained in exchange for each $1,000 of convertible asset held. In turn, the conversion price can be determined simply by dividing $1,000 by 25:
1,000 ÷ 25 = $40 per share
Comparison of a stock’s conversion price to its prevailing market price can help to decide the best course of action. If the stock of the company in question is trading at $52 per share, converting makes sense because it increases the value of $1,000 convertible to $1,300 ($52 × 25 shares). But if the stock is trading at $32 per share, then the conversion value is only $800 ($32 × 25), and it is clearly better to defer conversion.
Tricks of the Trade
Conversion ratios may change over time according to the terms of the agreement. This is to ensure that a convertible asset holder is not unduly advantaged and that the value of existing stock is not diluted—which, of course, would anger existing stockholders.
Stockholders, in turn, need to monitor closely a company that decides to issue a large number of convertible assets, since the value of their shares could ultimately be undermined.
Convertible bonds closely follow the price of the issuing company’s underlying stock. Often, in fact, the respective prices of the bond and the shares to be exchanged are almost equal.