What Is the If-Converted Method?
Investors use the if-converted method to calculate the value of convertible securities if they were converted into new shares. This is done by looking at the conversion ratio of the convertible security and then comparing the conversion price to the current market price of the stock.
The if-converted method also lets investors know how a company is doing in terms of earnings per share (EPS) based on the currency number shares, as well as earnings if all convertible securities were converted to common stock. If all convertible securities are converted to common stock, it is called diluted EPS.
- The if-converted method shows how EPS compares to diluted EPS, which is if all convertible securities became common stock.
- The if-converted method is also used by investors to see whether it is worthwhile to convert their convertible security into common stock.
- If the stock price is above the conversion price it may be worthwhile to convert, if they are willing to give up their creditor status and benefits.
Understanding the If-Converted Method
Convertibles securities are often bonds or preferred shares that inherently have the option to be converted into common stock. This is a feature that the issuer will add to the security at the time of issuance to “sweeten the deal” for investors.
A convertible gives investors more flexibility and the opportunity to potentially participate in the growth of the company by converting their convertible security into common stock. The price of the common stock generally rises when the company is performing well, and the overall market is performing well, providing the opportunity for larger gains than the interest or dividends received on bonds and preferred shares.
Convertibles are often associated with convertible bonds. These allow bondholders to convert their creditor position to those of equity holders at an agreed-upon price. Other convertible securities can include notes and preferred shares.
The number of shares an investor may receive is calculated on the basis of the convertible security’s conversion ratio. This is the ratio at which investors can convert bonds into stocks; that is, the number of shares an investor gets for each bond. The conversion rate may be fixed or change over time, depending on the terms that the issuer has set for the offering.
For example, a conversion rate of 25 means that for every $1,000 of par value the convertible bondholder converts, they receive 25 shares of stock. Investors can determine the price at which it becomes profitable to convert bonds into equity shares by dividing the selling price of the bond by the conversation rate to determine the breakeven price or worthwhile conversion price.
$1,000 / 25 = $40
In this case, if the stock price is above $40, it may be worthwhile to convert the bond. For example, if the stock is trading at $50, the investor receives 25 shares. Those shares are worth $1,250 (25 x $50), which is 25% more than the $1,000 par value of the bond.
The downside of converting is that the investor no longer receives the interest they were receiving from the bond. They are now subject to the ups and downs of the stock price; it could fall back below $40, or even much lower. Also, the investor loses their higher claim on assets should the company go bankrupt. Creditors get paid before common shareholders, so in the event of financial trouble, common shareholders are often the hardest hit.
If-Converted Method and Earnings
When a company reports earnings they typically provide EPS and diluted EPS, if they have any convertible securities outstanding. EPS is how much was made, per share, based on shares that were outstanding during the earnings period.
Diluted EPS is how much, per share, the company made if all the convertible securities were converted to common stock. Since there would be more common shares if all the convertible securities were converted, the diluted EPS is lower than EPS.
Some investors believe that diluted EPS is a truer measure of the value of a company than EPS.
Example of the If-Converted Method
For 2018, Apple Inc. (AAPL) reported earnings per share of $12.28. This was based on the number of weighted average shares outstanding, which was 4.736 billion shares.
Diluted EPS was $12.17. That means that if all convertible securities converted to common stock there would be 4.773 billion shares outstanding. Since there would be slightly more shares outstanding, the earnings would be spread across more shareholders, diluting the earnings per share.
When factoring for dilution, earnings would have been $0.11 lower had all convertible securities converted to common stock.
How Is the If-Converted Method Used to Calculate Diluted EPS?
If a company has potentially dilutive preferreds, subtract preferred dividend payments from net income in the numerator in the EPS calculation (i.e., from earnings(, and add the number of new common shares that would be issued if converted to the weighted average number of shares outstanding in the denominator (i.e., the number of shares).
What Is the Conversion Price of a Convertible Security?
The conversion price is the price at which a convertible bondholder can convert their bonds into common shares.
What Is the Conversion Ratio?
The conversion ratio is how many shares of common stock you would get at the conversion price for each convertible bond redeemed.