Convertible bonds
A bond that can become shares: count it as one or the other, never as both.
- Decide whether a convertible is treated as shares or as debt
- Calculate conversion shares, diluted shares and enterprise value
- Work out the conversion price from the shares a convertible would create
- Explain what the gap between the two treatments represents
The intuition
A company borrows $200 million with a twist: at any time, each lender may swap their bond for shares at $20 a share. That makes the $200 million worth 10 million shares.
If the shares trade at $25, those 10 million shares are worth $250 million, more than the $200 million the lenders would get back. They will convert, so the claim is really a claim of shares. If the shares trade at $15, the shares would be worth only $150 million, so they will keep the bond and take their $200 million: the claim is debt.
A convertible is either shares or debt, never both. If the share price is above the conversion price, count the conversion shares and leave the bond out of debt. If it is below, keep the bond in debt and add no shares.
Why it works
- Conversion shares = face value ÷ conversion price.
- In the money (share price above the conversion price): add the conversion shares to the diluted count and take the bond out of debt.
- Out of the money: the bond stays in debt at face value and adds no shares.
- No treasury stock method. A lender who converts hands back the bond, not cash, so there are no proceeds to buy shares back with. Every conversion share is new.
- The two treatments differ by conversion shares × price − face value: how much more the shares are worth than the bond. The correct treatment is always the one that gives the higher enterprise value.
| Conversion shares: $200M ÷ $20 | 10M |
| If converted: equity (100M + 10M) × $25 | 2,750 |
| If converted: EV 2,750 + 300 − 100 | 2,950 |
| As debt: equity 100M × $25 | 2,500 |
| As debt: EV 2,500 + 300 + 200 − 100 | 2,900 |
| Gap: 10M × $25 − $200M | 50 |
Counting the shares and leaving the $200M in debt as well would give 3,150: overstated by the full face value.
The formulas
How many shares the bond turns into.
Holders convert when the shares are worth more than the bond.
The claim is shares.
The claim is a loan.
How far the conversion option is in the money.
Worked example
Decide the treatment first, then build the bridge with the share count and the debt that go with it.
See it move
Same company. Move the share price across the conversion price and watch the right treatment change.
- Drag the share price below the conversion price. The gap turns negative: the bond is now worth more as debt, so it stays in the bridge at face value.
- Raise the conversion price. Each dollar of bond turns into fewer shares, and the point where the line crosses zero moves to the right.
- Double the face value. Twice as many conversion shares, and the gap between the two treatments doubles.
- Whatever you change, the right treatment is the one with the higher enterprise value.
Run it backwards
Same company, reversed: you know how many shares the convertible would create. What is its conversion price, and how far in the money is it?
Conversion shares are face value ÷ conversion price, so the conversion price is face value ÷ conversion shares. Compare it with the share price to see whether holders would convert.
Share price ÷ conversion price above 1 means in the money. The conversion shares at today's price, less the face value, is what the conversion option is worth right now.
Traps
Say it in the interview
“How do you treat convertible bonds when calculating enterprise value?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Conversion shares = face ÷ conversion price.
- In the money: shares, not debt. Out of the money: debt, not shares.
- Never both: that double-counts the claim.
- The right treatment gives the higher enterprise value.