Conversion ratio definition

The conversion ratio is defined as the formula that determines the number of shares of common stock that will be acquired during the conversion of a convertible security; typically the value of shares will vary throughout the life of the convertible security due to fluctuating market conditions. As a result, the conversion ratio of a bond may vary significantly during the duration of the convertible security and may offer significant opportunities for profit to savvy investors.

What is a convertible security?

In order to understand the conversion ratio, it is first necessary to define convertible securities. Any security that is structured so that it can be exchanged for another type of security at various points during its life is considered to be a convertible security. Most often, this is achieved by converting the security into shares of common stock issued by the same company that issued the security itself. Convertible securities can sometimes be converted into equity or even into another type of security, but generally are converted into common stocks.

Conversion ratio formula

The conversion ratio for a given security is calculated by dividing the par value of the convertible security by the conversion price of equity, that is, the agreed upon price for a share of common stock as listed in the contract. This calculation produces the number of shares of common stock that will be acquired during the conversion process. The formula can be expressed thusly:

• Conversion ratio = par value of convertible security / conversion price of equity

In general, higher conversion ratios are indicative of a better return on investment if the conversion option is exercised.

To convert or not to convert

It is usually to the investors advantage to convert a security to shares of common stock when the market value of a share of common stock exceeds the conversion price of equity, especially toward the end of the life of the security. For example, if the conversion price of equity listed in the contract is $20 per share and the companys stock is currently trading at $25 per share, the investor is entitled to convert the par value of the security into shares at the lower, agreed-upon rate of $20 per share. The investor can then sell those shares at the $25 per share price and pocket $5 per share as profit on the investment. In contrast, if the market price of the companys shares falls below the conversion price of equity, converting the security into shares would generally constitute a monetary loss. Thus, while the conversion ratio of a bond typically remains the same throughout its life, the profitability of actually converting the bond into shares can change significantly over time.