Some preferred stock issues have a convertible feature that allows holders to exchange their preferred stock for common shares. The conditions and terms of the conversion are set when the preferred stock is first issued. The terms include the conversion ratio, which is the number of common shares the preferred stockholder will get for each preferred share exchanged, and the conversion price of the common stock.
Preferred Stock Example
For example, Company XYZ issues a new convertible preferred stock that is sold at $100 per share and is convertible into five common shares of XYZ Company. The conversion ratio is therefore 5:1, and the conversion price is $20 per share for the common stock ($100/5 shares). If the market price of the common stock is $15, it is not advantageous for the preferred stockholder to convert because the value after conversion is $75 (5 shares at $15).
However, if the price of the common stock rises to $20, there is parity. The preferred stockholder would not convert because the preferred stock pays a dividend. If the common stock rises above $20 per share, the preferred stockholder can share in the capital appreciation of the common stock by converting to common stock.
When to Convert Preferred Stock?
The decision to exercise the conversion option depends on three factors:
- The market price of the common stock. It must be greater than the conversion price for the holder to share in capital gains.
- The amount of the preferred dividend.
- The amount of the common dividend.
The conversion feature provides the investor with the possibility of sharing in the capital gains through the appreciation of the common stock, as well as the relative safety of receiving the preferred dividends before conversion.
If the preferred dividend is much greater than the common dividend, holders would weigh this into the amount of the appreciation as to whether to hold the preferred or convert to common stock.