Convertible preferred stock
Convertible preferred stock allows investors to exchange their security for common stock of the same issuer. To better understand this type of security, we’ll cover these four subtopics in this chapter:
- Benefit to investors
- Dilutive actions
- Conversion logistics
- Anti-dilution covenant
Benefit to investors
Convertibility benefits the preferred stockholder, providing another way to make a return - capital appreciation. Preferred stock is a fixed-income investment, typically paying quarterly dividends to investors. Although its market price varies, very few investors purchase this type of security for growth. Preferred stock market prices are not as predictable or volatile for most investors to seek capital gains (a.k.a. capital appreciation or growth).
On the other hand, common stock’s primary benefit is growth potential. With average stock market returns around 10% annually, investors can make significant capital gains over long periods. Additionally, some common stocks pay cash dividends, allowing converting investors to continue collecting income.
Dilutive actions
The issuance of a convertible security is a dilutive action to the common stockholders, meaning it affects their proportionate ownership of the company.
To demonstrate this, assume you own 10 shares of a company with 100 shares outstanding, providing you with 10% ownership of the company. Also, imagine the business issues convertible preferred shares, which result in an additional 100 shares created upon conversion. If the convertible security owners convert all their shares, you now own 10 of the 200 outstanding shares (100 original + 100 new shares from the conversion), or a 5% ownership level. Issuance of the convertible security diluted your common stock ownership level. Because dilution negatively affects common stockholders, the issuer must obtain voter approval to issue convertible preferred stock or bonds.
Conversion logistics
Let’s go through some examples to familiarize ourselves with convertible preferred stock.
A $100 par, 5% convertible preferred stock with a conversion ratio of 4:1 is trading at $100 per share.
The conversion ratio details how many shares of common stock an investor receives if they convert the preferred stock. The issuer sets the conversion ratio at issuance, which generally stays fixed over the life of the investment. In this example, a converting preferred stockholder receives 4 shares of common stock for every preferred share owned.
Back to our example:
An investor purchases 100 shares of $100 par, 5% convertible preferred stock at $100 per share. The preferred shares maintain a conversion ratio of 4:1, while the common stock is trading at $15. A few years later, the common stock rises to $30. The investor converts their shares to common stock and immediately liquidates the position. What is the gain or loss?
Can you figure this one out?
Answer = $2,000 gain
Step 1: preferred stock purchase
Step 2: convert into common shares
Step 3: sell common shares
Step 4: compare the original purchase to final sale
In the last example, the investor made a profit because the common stock price increased. Convertibility benefits investors as it provides more return potential. Therefore, convertible preferred stock is issued with lower dividend rates than non-convertible preferred stock. Additionally, convertible securities are attractive in the market, which drives higher market prices and lower yields for these types of investments (the more expensive the investment, the lower the yield or rate of return).
Convertible preferred stock questions won’t always provide the conversion ratio, but they must always give enough information to find the conversion ratio. In particular, test questions typically provide the conversion price instead. The conversion price reflects the overall cost of the common stock (per share) if the preferred stock is purchased for par and converted. For example:
An investor purchases 100 shares of a $100 par, 5% preferred stock convertible at $25. What is the conversion ratio?
The formula for the conversion ratio is:
Using this formula, can you find the conversion ratio?
Answer = 4:1
For every share of preferred stock owned, the investor can convert it into 4 shares of common stock. Therefore, the conversion ratio is 4 to 1.
Sometimes, exam questions can provide the conversion ratio and ask for the conversion price. For example:
An investor purchases 100 shares of a $100 par, 5% preferred stock with a 4:1 conversion ratio. What is the conversion price?
The conversion price formula is very similar to the conversion ratio formula:
Using this formula, can you find the conversion price?
Answer = $25
Preferred stock bought at par ($100) can be converted into 4 shares of common stock. Essentially, the investor is paying $25 per share of common stock ($100 / 4), which is the conversion price.
Now, let’s dive into more complex questions.
An investor purchases shares of a $100 par, 7% preferred stock, which is convertible at $25 and callable at 102. A few years later, the preferred stock is trading at $103, while the common stock is trading at $26. If the issuer announces an upcoming call of the preferred stock in 60 days, which of the following options should you recommend to the investor?
A) Allow the shares to be called
B) Sell the preferred stock
C) Convert to common and sell the shares
D) Continue to hold the preferred stock
Can you figure out the best answer?
Answer: C) Convert to common and sell the shares
It’s your job to recommend the option that provides the most return to your customer. Three of the four choices are legitimate (A, B, and C). Answer choice D is not possible. Continuing to hold the shares beyond the call date is not a realistic option. The preferred shares will no longer pay dividends after the call, rendering them useless.
For answer choices A, B, and C, it’s best to determine how much each option provides:
A) $102 per share
The preferred shares are callable at 102, which means it will cost the issuer 102% of par ($100) to call. For every share owned, the investor receives $102.
B) $103 per share
The call feature does not kick in for 60 days. Therefore the preferred stock will continue to trade in the market. The market price is $103, providing the opportunity for the investor to sell their shares at that price.
C) $104 per share
If the investor converts, it’s essential to know the conversion ratio - divide par ($100) by the conversion price ($25), which is 4. With the common stock currently trading for $26, the investor can convert each preferred share to 4 common shares, which equals $104 of value (4 x $26).
With answer choice C providing the most value, it’s the best recommendation.
It is essential to understand the benefit of converting to common stock. Another way to determine if a conversion should occur involves parity price. There are two types of parity prices: preferred and common stock parity prices.
Let’s start with the common stock parity price, which investors utilize to determine the cost of the common stock if converted. The formula is:
An investor purchases shares of a $50 par, 4% preferred stock at $55. The shares have a conversion price of $10. What is the parity price of the common stock?
Can you figure it out?
Answer = $11
First, you’ll need to find the conversion ratio. The question provides the conversion price ($10). The calculation for the conversion ratio is:
For every 1 share of preferred stock, the investor may convert into 5 shares of common stock. From there, you can utilize the parity price formula for common stock:
The parity price establishes the price per share paid for the common stock if the preferred stock is purchased and immediately converted. A $55 share of preferred stock that’s convertible into 5 shares of common stock results in a “cost” (parity price) of $11 per share of common stock.
An instant profit exists if the common stock trades at any price above $11 per share. For example, assume the common stock is trading at $15. An investor could buy a share of preferred stock for $55, convert it into 5 shares of common stock, and sell all shares for $75 (5 shares x $15). The result is a $20 gain per share of preferred stock.
In the previous example, we discussed the opportunity for an instant profit. While it doesn’t frequently occur in the market, we refer to those events as arbitrage opportunities. Typically, these opportunities only last for minutes or seconds in the real world. Investors often need computer systems to scour the market for these fleeting moments. If spotted, the investor would likely go long and short simultaneously to lock in a profit.
Let’s go through a quick example to better understand this. Assume the numbers from the previous example:
Preferred stock market price = $55
Conversion ratio = 5:1
Common stock market price = $15
If a computer system identified this arbitrage opportunity, it would simultaneously buy shares of preferred stock and sell the corresponding amount of common stock short. Receiving the common stock from the conversion typically takes some time, and the market price may change in the meantime. The investor immediately locks in the $15 market price by selling it short. When the common shares are received from the conversion, the investor gives those shares to their financial firm to close out the short position.
Test questions may require you to identify arbitrage opportunities. If buying the convertible security, immediately converting to common stock, and selling those shares is profitable, it’s arbitrage.
There’s one more type of parity price to go through. The formula for the preferred stock parity price is:
An investor purchases shares of a $30 par, 4% preferred stock. The shares have a conversion price of $15, while the common stock is trading at $12. What is the parity price of the preferred stock?
Can you figure it out?
Answer = $24
First, you’ll need to find the conversion ratio. The question provides the conversion price ($15). The calculation for the conversion ratio is:
For every 1 share of preferred stock, the investor may convert it into 2 shares of common stock. From there, you can utilize the parity price formula for common stock:
The parity price establishes the overall value of the preferred stock based solely on the conversion feature. A security converted into 2 shares of common stock while the common stock is worth $12 per share results in the conversion feature being worth $24.
An arbitrage opportunity exists if the preferred stock trades in the market for less than $24. For example, assume the preferred stock is trading at $20. The investor could buy a share of preferred stock (at $20), convert it into common stock, and sell those shares for $24 overall. The investor makes a $4 profit per share of preferred stock.
Investors utilize parity prices to determine if they should convert to common stock. If the investor can make an instantaneous profit, an arbitrage opportunity exists.
Here’s a video that analyzes two different preferred stock parity price questions:
Anti-dilution covenant
Virtually all convertible preferred stocks are issued with anti-dilution covenants, an issuer’s promise to avoid diluting the value of the conversion feature. Before we discuss how the anti-dilution covenant protects preferred stockholders, let’s go through how dilution occurs without it.
Assume the following:
$100 par convertible preferred stock
Preferred stock market price = $100
Conversion ratio = 4:1
Common stock market price = $25
In this circumstance, the conversion feature is at breakeven (parity). If the investor buys a share of preferred stock at $100, converts it into 4 shares of common stock, and sells those shares for $100 overall ($25 x 4), they will not make or lose any money.
There’s a big incentive to convert if the common stock price rises further. You can safely assume employees of the issuer (e.g., the Chief Financial Officer) are keeping a close eye on this. While the issuer obtained stockholder approval to issue the convertible preferred stock, they aren’t thrilled if a significant amount of preferred shares start converting. Remember, conversion results in brand new shares of common stock, which dilutes the value and ownership level of every common stockholder (which likely includes the officers and directors of the issuer).
The issuer could do several things to manipulate the common stock price downward, resulting in the conversion feature having less value. In particular, stock splits would do the job. Again, assume the following:
$100 par convertible preferred stock
Preferred stock market price = $100
Conversion ratio = 4:1
Common stock market price = $25
2:1 stock split
- Pre-split common stock price = $25.00
- Pre-split conversion value = $100 ($25.00 x 4)
- Post-split common stock price = $12.50
- Post-split conversion value = $50 ($12.50 x 4)
*Stock splits were initially covered in this chapter.
A 2:1 stock split results in twice as many outstanding shares, with each share trading at half its original value. This results in the conversion feature losing half its value. Before the stock split, the conversion netted $100 of common stock ($25.00 x 4), but after, it only netted $50 of common stock ($12.50 x 4). At this point, conversions are unlikely to occur. The convertible preferred stockholders were diluted in this example.
Anti-dilution covenants require the issuer to adjust the conversion feature if a stock split occurs. Specifically, the issuer will change the conversion price and ratio to offset the dilution. Let’s explore this idea with a question:
An investor purchases a $100 par, 5% convertible preferred stock with a conversion price of $50. The common stock is currently trading at $40. The issuer performs a 4:1 stock split on the common stock. What is the adjustment to the conversion price and ratio if the preferred stock contains an anti-dilution covenant?
Let’s walk through this one together. The first step is to find the original conversion ratio.
Each share of preferred stock is initially convertible into 2 shares of common stock worth $40 each, resulting in an $80 conversion value ($40 x 2). If a 4:1 common stock split occurs, the share price will fall significantly.
With the common stock’s price falling to $10 per share, the conversion feature’s value drops to $20 if it doesn’t adjust (converts into 2 shares worth $10 each). With the anti-dilution covenant, the issuer will adjust the conversion price and ratio appropriately. Remember, they must make the proper change to retain the original conversion value of $80. Let’s start first with the conversion ratio.
To find the new conversion ratio, simply multiply the current conversion ratio (2) by the stock split factor (4) (again, review the stock split section if you don’t know how to find the stock split factor).
Because the issuer created 4 times the number of common shares outstanding, the preferred stockholders should receive 4 times the original amount received at conversion. If the investor converts now, they’ll receive 8 shares of common stock worth $10 each, representing a conversion value of $80 (8 x $10). Now, the original conversion value is matched.
Do you know what the new conversion price would be?
Answer = $12.50
You can find this one of two ways. First, let’s only use the stock split factor. A 4:1 stock split results in a stock split factor of 4 (4/1). We multiplied this number times the conversion ratio to find the new conversion ratio. You’ll need to divide the original conversion price ($50) by the stock split factor (4) to find the new conversion price.
You can calculate the new conversion price another way. The new conversion ratio is 8, so you could perform the traditional conversion price formula:
Either way works! Feel free to use whichever method is more comfortable for you.
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