What Is Conversion Value?
The term conversion value refers to the financial worth of the securities obtained by exchanging a convertible security for its underlying assets. Convertibles are a category of financial instruments, such as convertible bonds and preferred shares, which can be exchanged for an underlying asset, such as common stock.
Conversion value is calculated by multiplying the common stock price by the conversion ratio.
- Conversion value is the amount an investor would received if a convertible security is changed into common stock.
- This value is arrived at by multiplying the conversion ratio (how many shares received per bond) by the market price of the common stock.
- Conversion value calculations are useful in determining break-even or floor values involved with holding convertible securities.
Understanding Conversion Value
As with types of investments such as stock options, a key objective with a convertible security is to hold onto it until the market price is higher than the conversion value, thus generating profit through the conversion and later sale of the common stock received.
The conversion value is closely related to the market conversion price or parity value, which are used to identify break-even values at a particular stock price. The conversion value, on the other hand, calculates what the net value would be to a conversion done right now at current market prices in the stock.
A convertible security that is trading at a price above its conversion value is said to have a conversion premium. This makes the security valuable and desirable. A convertible security is considered "busted" when it is trading at a price far below its conversion value. If the price of the underlying security falls too far below the conversion value, the convertible security is said to have reached its floor.
How Conversion Value Is Determined
Understanding what the floor value is for convertible bonds can help the bond holder determine when the underlying asset is worth converting. This includes knowing the face value for the bond. For instance, typically, when a convertible bond reaches maturity, the holder gets the face-value principal payment that is equal to the amount they initially paid for the bond. The bond has also been generating interest over the course of the maturity period.
The floor value can be determined even before the bond reaches maturity through a calculation. Adding the principal payment to the interest payments, or bond yield, that have been received and are expected until it reaches maturity will result in the floor value. That is the figure that can be used for comparison against the conversion value to assess the worth of the securities.
In many examples, it is not profitable to exercise an option to convert, if allowed, before a convertible security matures. There may be stipulations that require the security to be held until it reaches a certain conversion price. It might be necessary for the issuers of convertible notes to bifurcate, or divide the fair value or price of a convertible bond between fair values for the conversion aspect and for the straight debt, which cannot be converted.
Example of Conversion Value
Suppose that investor owns convertible bonds in XYZ Corp., and decides to utilize the call option in order to convert those bonds into common shares of the company.
Assuming that the bond’s conversion ratio is 50 shares per bond, and the bond shares of XYZ stock are trading at $20, then the conversion value of one bond would be $1,000 (i.e. 50 x $20)