Convertible preferred stock gives you a way to collect fat dividends and benefit from higher common stock prices. Convertible shares pay a fixed dividend and holders receive sale proceeds ahead of common stock shareholders when a corporation liquidates. But convertible shares pack an extra wallop: You can convert them into a fixed number of common shares.
A corporation sells preferred shares through an initial public offering. The offering prospectus discloses the issue price, known as the par value, and the conversion terms. The conversion date, if present, is the first date on which you can convert the shares. The conversion ratio is the number of common stock shares you’ll receive for each share of convertible preferred you choose to convert. When you divide the conversion ratio into the par value, you get the conversion price -- the price the common stock must exceed to make conversion profitable.
The conversion premium is the difference between the value of the preferred shares if converted and the par value. A positive premium indicates how much profit per preferred share you’ll earn via conversion. As a common stock’s price rises above the conversion price, the common shares pull the convertible stock’s price higher. If you hold convertible shares with a positive conversion premium, you can convert them to common stock and immediately sell the common shares for more than you paid to buy the preferred shares.
Executing the Conversion
Most brokers have a web page on which you can enter a conversion order. If not, a phone call to your broker will suffice. The broker will replace the convertible shares in your account with the appropriate number of common shares, based on the conversion ratio. Once the shares are converted, you can hold onto the common stock or sell it immediately. As an alternative, you might make the same profit by simply selling the convertible shares.
Suppose you purchase 50 shares of convertible preferred stock issued by XYZ Corp. for a par value of $100 per share, a total cost to you of $5,000. XYZ convertible preferred stock has a conversion ratio of 6.5. By dividing 6.5 into $100, you obtain the conversion price of $15.38, which is the break-even price for converting the shares. The common stock is currently selling for $9 a share, so each converted preferred share is worth 6.5 times $9, or $58.50. The conversion premium is $58.50 minus $100, a negative number: Conversion would lose money. If XYZ suddenly announced record earnings and the common stock jumped to $20 a share, you could convert your 50 preferred shares into 325 common shares worth $6,500, creating a profit of $1,500.
- Investing In Preferred Stock: An Introduction for Modern Income Investors; Paul Josephs
- Stock Investing for Dummies; Paul Mladjenovic
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.