 Personal Finance PowerPoint Presentation, Convertible Preferred Stock. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Convertible Preferred Stock, which you can find online. Take a look at the references, resources, continue your research from there. This is by Corey Mitchell, Updated May 17, 2022. In the prior presentations, we've looked at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investment. That being fixed income, usually bonds and equities, usually the common stock. Here, we're looking at convertible preferred stock, which technically falls into the equity, but in actuality, it's kind of a hybrid or acts like a hybrid between the two, between the fixed income and the equity. Remember that the bonds we can think of as in essence, us giving a loan to the issuer of the bond, either a corporation or the government in exchange for having the fixed income, typically in the form of interest payments, then the principal payment or the amount of the face amount that's going to be received as a lump sum at the maturity. When we think about the stocks, we're thinking about a corporation, a separate legal entity, ownership and the form of stocks, each stock representing equal ownership in the corporation. The corporation's typically being a publicly traded company because when we're thinking about investing, we're usually thinking about investing in publicly traded stocks, which are on a stock exchange, making it easier for us to invest in them, making them more transparent in nature. Keeping those in mind, we're now going to be considering what is convertible preferred stock. Convertible preferred stock are preferred shares that include an option for the holder to convert the shares into fixed number of common shares after a predetermined date. When we looked at preferred stock in general in a prior presentation, which again is an equity instrument, but it acts as a hybrid in its behavior in that typically you're going to get payments that are going to be the dividend payments, which are not as guaranteed as the debt payments, bonds. In other words, in other words, if the corporation doesn't pay the bond interest payments, they're going to default and the company's going to have big problems in that case. If they can't pay the preferred stock, then they may not have to pay the dividends, but if they don't, depending on the kind of preferred stock, they might have to pay the dividends in the future before they can pay the common stock. That's why it's preferred because they're typically going to pay out the preferred dividend. Again, preferred doesn't mean that it's better than common stock. It just means that it's got this feature that's beneficial to it and that you get paid before in terms of the dividends before the common stock. So you can see the income is more fixed in nature, but it's not completely fixed as to with the bonds. And then of course, if they were to liquidate the company, meaning they go out of business or bankruptcy, for example, they have to pay the liabilities first and then they will typically pay the bondholders first and then the preferred stockholders and then the common stockholders. So on the other hand, so that's why it would be a beneficial thing. On the other side of things, the common stock usually has more upward potential and it usually has the voting rights. Clearly, common stock has a voting for the board of directors. And you can usually, if the value of the company goes up in value, that's usually going to be more beneficial, meaning it's going to be reflected in the value, the price of the common stock, more than it will be changing the preferred stock, meaning the preferred stock acts kind of more like a bond in that nature. Okay, so now we've got this convertible component to it similar to basically a bond. And now remember, most people, when they're investing, they're thinking, I'm going to invest in things that are straightforward and simple usually, meaning a stock is a stock and the reason we invest in those is because it is a straightforward equity investment that we've tried to make as straightforward as possible and a bond is a bond and we can compare those things because of their simplicity. When we add components to it, such as this preferred stock in general, which is kind of like a hybrid instrument, it could be a little bit tricky to kind of fit how it fits in the portfolio, so you've got to keep that in mind. And then as we add more components to it, like features to it, convertibleness, then that also adds a little bit more complexity. So we don't want to be sure that if we're investing in those kind of instruments that we are cognizant of why we are doing so. Okay, so now we have this capacity to convert to the common shares in a similar way as we saw with the bonds that could have a convertible feature. Okay, so most convertible preferred stock is exchanged at the request of the shareholder. So usually if it's got the convertible component to it, it's usually beneficial to the shareholder if the shareholder is the one that gets to trigger the conversion process because now they have the capacity to convert it to the common stocks if they so choose. So that means they've got some capacity for the upside. So they've got the benefit if there's a downside because if things go down they get paid first on the dividends and they get preferred payment if there's a liquidation and they have some access to the upside because if the company goes up then the stock value will go up and they can convert their shares at that point. But sometimes there is a provision that allows the company or issuer to force the conversion so that's going to be a little bit different of a scenario clearly. So now you've got the power on the company side of things to force a conversion. The value of a convertible preferred stock is ultimately based on the performance of the common stock. So now clearly the preferred stock is linked to some degree to the common stock because if there's upward momentum then there's going to be valuation to the convertible component to it. Understanding convertible preferred stock. Corporations use convertible preferred stock to raise capital money in essence to invest. They are especially favored by early stage companies as a financing medium. Companies can typically raise capital in two ways. You've got debt or equity. So if I want to make money we're trying to get money so we can invest it in machinery and equipment so we can generate more revenue in the future. We can do so by issuing debt. Bonds typically oftentimes if you're issuing to the public. But the downside of that is you've got to pay back the interest of course on the debt or you can issue equity and the downside of normal equity stocks is that you're now giving equity interest in the company. They're giving part of the value of the company and you're giving some of the voting rights so they can vote for the board of directors and so forth. So those are the two ways to generate the capital to grow the business typically. Now we've got this preferred stock component going in. So debt must be paid back regardless of the firm's financial situation but is generally less costly to the firm after taking into account tax incentives meaning the debt to the company can be cheaper due to taxes because they get to write off the interest payments that they're making as an expense. So equities give up ownership but does not need to be paid back so on the equity side of things you don't have to give back the dividends where if you don't pay the interest payments on the debt you're going to be in trouble. So both forms of financing have their advantages and disadvantages. Preferred shares fall somewhere in between debt and equity on the risk scale as the incorporate features of both. So now preferred stock in general is in the middle kind of like a hybrid. So equity provides shareholders with an ownership stake that in turn gives them voting rights and a say to how the company is run. However equity holders have little claim to assets if the company falters and eventually liquidates because if a company liquidates they're probably in a bad financial position and they're probably not going to be paying much to the stockholders because they have to pay the liabilities first and then the debt holders and then the preferred stock and so on. So this is because debt holders are preferred shareholders and preferred shareholders have priority in terms of claims on the company's assets with common shareholders only paid out from any residual assets. Preferred stock is a hybrid security that gives the shareholder a fixed dividend and a claim on assets if the company liquidates. So preferred's kind of in the middle because now you've got more of a fixed payment not as fixed as the debt because the company is not required to pay it. They won't default if they don't pay it but they generally have to pay it or possibly have to pay it before they pay the preferred shareholders and if they liquidate they have a claim behind the bondholders but still above the preferred or the common stockholders. So in exchange preferred shareholders don't have voting rights like common shareholders do so they can't vote. Preferred and common stock will trade at different prices due to their structural differences. Preferred stocks aren't as volatile resembling a fixed income security. In other words the common stock you would think there's going to be a lot more peaks and dips in the activity because it's more reflective of the valuation of the company kind of as a whole of the perceived value whereas the preferred stock is closer to a fixed income and therefore it's going to act kind of more like a bond. So there are many different types of preferred securities including cumulative preferred, callable preferred, participating preferred and convertibles. Convertible preferred stock provides investors with an option to participate in common stock price appreciation. Preferred shareholders receive an almost guaranteed dividend. However, dividends for preferred shareholders do not grow at the same rate as they do for common shareholders. In other words if the company does well they don't have as much benefit on the upside of things. So in bad times preferred shareholders are covered so they're good on the bad times so you're covered in the bad times but in good times they do not benefit from increased dividends or share price. So this is the trade-off. Convertible preferred stock provides a solution to this problem in exchange for a typical lower dividend compared to non-convertible preferred shares. Convertible preferred stock gives shareholders the ability to participate in share price appreciation. So if you've got a convertible you're getting a little bit of the best of both worlds meaning if there's a downturn you're going to say okay well that means I'm just going to take my preferred dividends and if they liquidate then I'm at least above the lineup before the common stock to get paid first and if there's an upside then I convert. I just convert it to common stock and I get the valuation of the higher shares and the dividends that are going up on the good times. So convertible preferred stock terms commonly used terms when referring to convertible preferred stock are as follows. We've got the par value. That's the face value of the preferred stock or the dollar amount payable to the holder if the company were to go bankrupt. We've got the conversion ratio. The number of common shares an investor receives at the time of conversion of a convertible preferred stock. So if you convert it how many shares are you going to get? The ratio is set by the company when the convertible preferred stock is issued. We've got the conversion price. The price at which a convertible preferred share can be converted into common shares. The conversion price can be calculated by dividing the convertible preferred stock's par value by the stipulated conversion ratio. And then we've got the conversion premium. The dollar amount by which the market price of the convertible preferred stock exceeds the current market value of the common shares into which it may be converted may also be expressed as a percentage of convertible preferred stock's market price. So let's give an example of the convertible preferred stock. Shall we consider a convertible preferred stock issued by the hypothetical company ABC Incorporated at $1,000 for a conversion ratio of 10 and a fixed dividend of 5%. The conversion price is thus $100 and ABC common shares need to trade above this threshold in order for the conversion to be worthwhile for the investor. So even if the common shares are trading close to $100 it may not be worth it to convert since the preferred shareholder will be giving up their fixed 5% dividend and higher claim on company assets. If the convertible preferred stock is trading at $1,000 and the ABC common shares are trading at $80 the conversion premium would be $200 i.e. that's going to be the 1,000 minus the 80 times 10 or 20% or 20% 200 over the $1,000. So if the common shares move up to $90 the conversion premium shrinks to $100 or 10%. So thus the conversion premium influences the price at which the convertible preferred trades in the market a high conversion premium implies that the underlying common shares are trading well below the conversion price and there is little possibility of a profitable conversion. In this case the convertible preferred stock will act more like a bond and will be susceptible to changes in interest rates. So if the conversion premium is very low implying that the common stock is trading quite close to the conversion price the convertible preferred stock will be sensitive to changes in the underlying common shares those of ABC in this case and will act like straight equity. So obviously if it doesn't look beneficial to make the conversion because things are going down for the company then you would think that the conversion preferred stock would act more like a preferred stock and be more like a bond in its nature. If it's going up, if things go up and the conversion feature looks like a beneficial component the more beneficial, the more benefit there would be to converting the more it's going to act like the equity valuation. So as the common shares rise it becomes more attractive to convert. If the ABC common shares move to $110 the preferred shareholder gets $1,100 that's $110 times 10 for each 1000 preferred stock. That's a gain of 10% if the investor converts and sells the common shares at $110. The danger in converting is that the investor becomes a common shareholder at the mercy of the swings in the stock price. So in other words once you convert then at that point now you've got common stocks which are subject to all the volatility at that point. So if you were to convert and it was beneficial to do given the valuations but you didn't sell it right after the converting you just you hold on to it and then the price went back down now you're subject to that decrease in the price whereas when you were holding on to the convertible stock you weren't subject to the decrease in the price so much because you can default back on the preferred stock in it acting more like a bond. So if the price of ABC stock falls to $75 after conversion and assuming that the investor continues to hold the common shares they would now own 750, 75 times 100 in common shares for each preferred stock worth $1,000 that they previously owned. This represents a national a notional loss of $250 and the investor no longer receives the 5% preferred stock dividend or preferential claim on assets.