How Does Stock Conversion Work?

Preferred shares may be converted to common shares under certain conditions.
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There are several investment vehicles that the holder may exchange for common stock shares when certain conditions are met, usually involving a set price and date. This process is known as a conversion, and the investment vehicles that may be traded in may have the word "convertible" in their name, such as convertible securities or convertible bonds. Other types of investments that may be converted include debentures and certain types of preferred stock shares.

How It Works

When an investor purchases a convertible security, it comes with an agreement that the investor may exchange it for a set number of common shares after a set date. When the date arrives, the investor must weigh the value of the security against the value of the common stock he would receive and decide whether to convert the security. Sometimes, however, the security's issuer may force a conversion -- meaning the investor has no choice in the matter. For example, an investor buys 100 shares of convertible preferred stock that may be exchanged for 300 common shares in one year's time. In a year, if the preferred stock is valued at $10 a share and the common stock at $5 a share, the investor would be able to turn $1,000 worth of shares into $1,500 worth by making the conversion.

Downsides to Conversion

There are two major issues with stock conversion. The first is that, depending on the prices of the investment vehicle and the common shares, a conversion may not be advantageous to the investor. For instance, if the 100 shares of convertible preferred stock were valued at $10 each, but the 300 shares of common stock were valued at only $2 each, the investor would be converting $1,000 into $600. In the event the company forces the conversion, the investor would have no choice but to take the loss. In addition, any conversion by its very nature dilutes the value of the company's common shares by creating more of them. A conversion price may also decline in the event of stock splits or dividend issuance.

When to Convert

Because some convertibles, such as preferred shares, may see their price rise and fall, investors need to keep track of the common stock price to determine when the conversion is worthwhile. By dividing the price of the convertible by the ratio of common stock shares, an investor can determine when a sale will turn a profit. For example, if each convertible is priced at $10 and the investor gets three common shares for each convertible, a value of $3.34 (after any fees) would allow the investor to profit on the conversion.

Other Types of Conversions

Stock conversion involving convertible securities should not be confused with other types of conversion, such as stock options conversion or mutual-to-stock company conversion. Stock options conversion involves taking advantage of an overpriced option to turn a risk-free profit for the converter. A mutual-to-stock conversion takes place when a company owned by members -- such as a mutual insurance company -- converts to a stock-based ownership system.

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