What is a Conversion Ratio?
A conversion ratio is the number of one security given for another security (usually a convertible security).
How Does a Conversion Ratio Work?
For example, convertible preferred stock is preferred stock that holders can exchange for common stock at a set price after a certain date. Let's assume you purchase 100 shares of Company XYZ convertible preferred stock, which pays a 5% dividend, on June 1, 2006. According to the registration statement, each share of preferred stock is convertible after January 1, 2007, (the conversion date) to three shares of Company XYZ common stock. (The number of common shares given for each preferred share is the conversion ratio. In this example, the ratio is 3.0.)
If after the conversion date arrives Company XYZ preferred shares are trading at $50 per share and the common shares are trading at $10 per share, then converting the shares would effectively turn $50 worth of stock into only $30 worth of stock (the investor has the choice between holding one share valued at $50 or holding three shares valued at $10 each). The difference between the two amounts, $20, is called the conversion premium (although it is typically expressed as a percentage of the preferred share price -- in this case it would be $20/$50, or 40%).
By dividing the price of the preferred shares ($50) by the conversion ratio (3), we can determine what the common stock must trade at for you to break even on the conversion. In this case, Company XYZ common must be trading at a minimum of $16.67 per share for you to seriously consider converting.
Why Does a Conversion Ratio Matter?
Conversion ratios influence the trading prices of convertible securities. That's because the conversion ratio dictates the conversion premium. The lower the conversion premium, (that is, the closer the preferred shares are to being “in the money,”) the more the price of the security follows the price movements of the security into which it converts.