Convertible securities, comprising convertible debt and convertible preferred stock, represent a hybrid ownership interest combining features of both “straight” debt and common equity. Like fixed income securities, convertibles typically have periodic interest or preferred dividend payments, stated par values/liquidation preference amounts, maturity dates, and call dates. At the same time, convertible securities are exchangeable at some price or conversion ratio into the common shares of the issuing company.
Convertibles provide current income through scheduled interest or preferred dividend payments and a floor value through the par value or liquidation preference as well as additional appreciation potential through the common share conversion feature. For companies needing cash, convertibles offer a means to reduce current borrowing costs by “buying down” the interest or preferred dividend rate by offering the security holders the ability to profit from future appreciation in the issuer’s common stock. For classes of investors (such as leveraged employee stock ownership plans and owners of acquired companies) requiring downside protection and/or current cash flow exceeding whatever dividend the issuer is paying on its common shares, convertibles offer a means of meeting those objectives while still retaining a stake in any appreciation in the company’s common equity.
Given their hybrid nature, convertible debt and convertible preferred stocks are typically issued with coupon or dividend rates below the market yields for comparable “straight” bonds and preferred stocks. At the same time, convertibles are also commonly issued with “out of the money” exchange ratios; that is, the conversion price is set at a premium to the current market price of a common share.
For example, if the prevailing yield on medium grade corporate bonds is 8.0%, a convertible issue of comparable credit quality, maturity, and callability might be issued with a 5.0% coupon. If the issuer’s common stock was trading at $20.00 per share, the exchange ratio might be set at 40 shares per $1,000 par bond, or $25.00 per share. The investor thus trades coupon income for upside potential in the event of enhanced corporate performance or higher stock market multiples while the issuer trades potential future dilution of its common share values (in the event of conversion) for lower current financing costs.
Under current financial theory, in general, the minimum value of a convertible security should be the greater of its value as a pure fixed income security or its value as a common share equivalent. Thus, if the net present value of the coupon income and par value exceed the value to be realized by immediately converting the security to common stock and selling the shares at the current market price, the security would be expected to trade at a price not less than its value as a “straight” bond or preferred stock. Alternately, if immediately converting the security into common shares yields a value exceeding the present value of the scheduled cash flows, the security would be expected to trade at a price not less than that implied by the conversion ratio multiplied by the current common share price. Because of the hybrid nature of convertibles, they typically trade at some premium to the prices implied by their pure bond values or their conversion values.
From a valuation perspective, convertibles can be modeled in two ways: first, as a “straight” bond or preferred stock with an embedded option or warrant to purchase the issuer’s common stock at the conversion price; and, second, as a bundle of common shares carrying the right to additional current income over some time horizon. Thus, the bond value is enhanced by the value of the embedded warrant while the common share equivalent value is enhanced by additional current income.
If we add the assumptions of a seven year maturity and semi-annual coupon payments to the hypothetical 5%, $1,000 par bond convertible into 40 common shares currently trading at $20.00 per share, we can infer a market value under the model of a bond with attached call options. Discounting the coupon income and the par value at a market yield to maturity of 8.0% implies a bond value of $841.55. The embedded warrant can be valued using a standard option pricing model such as a variant of the Black-Scholes or Binomial models. Let us assume that the option pricing model calculates a value of $4.00 per warrant share, or $160.00 for the 40 common shares under option. The resulting total value of the convertible security is thus $1,001.55 per bond, approximating par.
The same hypothetical security can be valued as a bundle of common share equivalents with additional investor cash flows attached. Multiplying the 40 common shares per bond by the $20.00 per share market price implies a conversion value of $800.00. The present value of the right to receive semi-annual payments of $25.00 for seven years discounted at 8.00% annually is $264.08. The total value implied is thus $1,064.08, a modest premium to par. This example assumes no common dividend. If the common stock paid a dividend, then only then only the present value of the cash flows on the convertible in excess of the common dividend would be added to the current conversion value.
This hypothetical security would be expected to trade somewhere between par and 106% of par; that is, between the indicated value as a bond with attached warrants on common stock and the indicated value as a bundle of common share equivalents with additional current income.
The preceding example incorporated simple terms and assumptions. Most convertible issues include call features allowing the issuer to redeem the shares prior to maturity, thereby forcing the holders either to be cashed out or to exercise their conversion rights early. In theory to maximize the value of its common stock, the issuer should redeem the convertible as soon as the conversion price is “in the money” relative to the market price of the common stock; otherwise, common shareholders are diluted by the existence of a group of equityholders having both the right to extra cash flows and the right to require the company to issue to them common shares for consideration (i.e. the conversion price) at or below the current market price. The presence of a call or redemption feature complicates the modeling of the embedded warrant on the issuer’s common shares as well as the modeling of the scheduled cash flows of the convertible security.
Where the issuer’s common stock is closely held or the shares to be received in conversion are not to be registered and/or the convertible security is unregistered or otherwise not readily marketable, valuation becomes further complicated. It will likely be appropriate to apply a marketability discount to the common stock and to add an increment for illiquidity to the pricing yield for the fixed income component of the convertible. In valuing the embedded warrants, adjustments must be considered to reflect any lack of marketability in the common shares, non-transferability of the embedded warrants, the inability to separate the warrants from the fixed income component of the security (that is, the right to call the shares cannot be exercised without terminating the scheduled cash flows), and the potential dilution of common share values due to the issuance of new shares upon conversion.
If you wish to discuss an appraisal or structuring of convertible debt or convertible preferred stock please contact us at (901) 685-2120.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 2, No. 2, 1999.