The term convertible preferred stock is used to describe one of several classes of preferred stock that can be issued by a company. To add to the marketability of this investment, convertible preferred stock provides the holder with the right to exchange this investment for shares of common stock.
The number of shares of common stock received for each share of convertible preferred is known as the conversion ratio. Therefore, the conversion price is calculated as:
Conversion Price = Price of Preferred Shares / Conversion Ratio
The ability to convert preferred stock to shares of common stock is typically granted on a certain date or after a predetermine timespan elapses. The price of convertible shares tends to move in step with the price of the company's common stock. If a company demonstrates through earnings, or other means, that it will prosper in the future, and its common stock rises, this is to the benefit of the preferred stockholder.
The convertible preferred stock has the additional advantage of preference with respect to dividends, as do all holders of preferred stock.
Company Z's preferred shares of convertible stock were sold at a market price of $70 and a conversion ratio of 7. The break even conversion price is:
= $70 / 7, or $10 per share
When the price of Company Z's stock rises above $10 per share, then the conversion will be profitable for this investor.