Convertible preferred stock (FINRA SIE, Series 7)

In this video, Achievable author Brandon Rith explains how to find the parity price in a convertible preferred stock question that you will likely see on the FINRA SIE or FINRA Series 7 exams.

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Full Convertible preferred stock (FINRA SIE, Series 7) video transcript:

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Convertible Securities can be a difficult topic. Master, especially with those math-based questions, involving lots of numbers calculations. But let's spend some time demystifying, what's happening? Look at the formulas, that we might need to use for these types of questions. It's figure out exactly what's going on. Let's go ahead and look at a practice question together. Okay? Peyton Incorporated hundred-dollar par 4%. Convertible preferred stock is trading at 105. The conversion price is $10 and Peyton Inc. Common stock is trading at $8. What is the Perry price of the preferred stock? Okay, that's a lot of information. They've given us and just a few sentences. Why do numbers in like with most math face questions? Where calculations are required to be performed? Some of these numbers are probably going to be used in some of them are not. So let's go ahead and pick it apart sentence by

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Let's, let's go back to that first and it first painting Inc. $100 par boss. Hundred-dollar par is basically the face value of this preferred stock investment. The par value is important for a couple of reasons. First and foremost, a lot of Securities Lake preferred soccer issued at the par value. Same thing with the lot of bonds. That's not always the case but that usually happens. The par value is also important because that is what the dividend rate for preferred stock is based upon an extra if we go to the next number in the question 4%, 4 percent of $100 is $4 this preferred stock pays $4 in annual income. And if it's like most preferred stock out there, it makes semi annual payments except for taking big picture here. This preferred stock makes two $2 payments during the year for a total of $4, it did, it's the last reason. The par value is important is because if the

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Preferred stock has ever called in the future. It's usually the basis for that call. So for example, a lot of preferred stocks that are callable if they're called, they're usually called at par maybe post a call Premium. So for example of whose poor plus $2, that would be, the $2 would be be call Premium. But again, the hundred-dollar par value is the basis for the Security Bank called if it's even callable not every preferred stock is call Apple. Now, technically stock has no end, it doesn't mature at any point time of the future like a boss. If this was a bond, then whatever this Bond would mature than the par value will be paid back to the investor at maturity but that's not what happens here. 105 in this question is what we refer to as a percentage of par quote, we see this with bonds as well whatever we see a number just given to us and it's reference as its trading price with no dollar sign. It's almost over.

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In reference to a percentage of Park. What, what is that mean? In plain English, this preferred stock is trading at 105% of its par value, which happens to be one hundred and this is pretty simple, what's 105% of $100? It's just $105. So this convertible preferred stock is trading in the Market at $105, that will come into play later. So far in the first sentence, that's what we'd established hundred-dollar, par Value stock is paying, what was it $4 a year in annual dividends? It is trading in the Market at $105 per share

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Let's go to the second sentence. The conversion price is $10. Let's pause their conversion. Price is a very important element of any convertible question, you come across one thing, you're not seeing in this question, is reference to the conversion ratio. In fact, let's actually start with the conversion ratio first. The conversion ratio is arguably the most important aspect of any convertible question that you come across. If you know anything about a convertible security, it means that we have a security that's paying dividends in this case $4 in dividends every year.

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But we also have the ability at any point time to call Upper broker or maybe walking online and click a button and magically. This preferred stock will turn into a specific number of shares of common stock in the same company.

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Some plain English. We've got it. Peyton ink convertible, preferred stock. Let's say we have one share of it. We can convert that into a specific number of common shares in the same company. Picnic, you might be wondering why someone would convert preferred stock into common stock. And the main reason this may occur is Shifting priorities of the investor preferred stock is primarily an income paying security investors tend to purchase them just for their dividend rate. So again take for every share I own in this preferred stock it just pays me $4 a year dividence. Most preferred stock investors don't really have too much access to what we call. Capital appreciation are capital gains.

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Capital gain just means, Buy Low, sell High. The primary driver of preferred stock is actually interest rates and they have an inverse relationship with interest rates. Just like a bond us. When interest rates, go down, preferred stock prices, go up and vice-versa when it's your kids. Go up for Sockeye is go down, interest rate, changes are somewhat unpredictable. So most investors don't really rely on her for a stock for capital gains. On the other hand we basically have the opposite scenario with common stock can, stock pay a dividend to shareholders. Yes. Some companies pay dividends on their common stock. NOW, most common stocks in the market don't pay dividends on their common stock and let's assume that Peyton, stock in. This example doesn't pay dividend, what benefit does, chakra. Lee provide an investor capital appreciation are capital gains, Buy Low, sell high. That is the primary reason why investors put their money in the common stock.

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Common stock prices are primarily driven by how successful company is if a company does really well with more Revenue sells more of its products. And services, its price typically will go up in the market because his investors will demand that stock more. So, in the market, now, that doesn't really happen with preferred stock.

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Preferred stock. Is it fixed income investment in? No matter how well the company does. They're not going to pay you extra dividend unless maybe the shares are participating in these shares will assume or not. Participating, by the way, in case you wondering participating preferred stock is preferred stock that pays more dividends when the company is more successful financially. But again, we have no indication that these are participating shares and therefore we will not assume, they are so big picture here and investor would convert preferred stock in the common stock. If they're looking to leave an income paying investment and move their money more. So into an investment, that's more eligible for growth. Maybe this investors, like, hey, I'm done collecting, just $4 and measly dividends per share. Here, I want to convert it in the common stock and let's see if that market price will rise to the Moon. All right, let's go ahead and get back to the original point. The conversion ratio is the most important part.

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I'm really any math base, convertible question and it was not provided to us in the question. But the conversion price was, let's go ahead and put the conversion ratio Formula in front of the conversion. Ratio is equal to be par value /, the conversion price. And if we take the $100, par value in /, the conversion price of 10, we get a conversion ratio of pain. We might say ten to one. That means, if we decide to convert are one share of preferred stock, we will get 10 shares of common stock. My biggest advice to you when you approach a math page. Convertible question is identify the conversion ratio? As soon as you can, sometimes it'll be provided to you in the question. And if it's not, then they have to give you the conversion price. What they give you the conversion price again, take the par value /, the conversion price and you had the conversion ratio. All right, we'll keep track of that 12:50 conversion ratio, but let's go ahead and get to the

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End of the second sentence. Payton income, stock is trading at $8 knowing the market. Price of the common stock is actually a pretty important thing for the investor. Why it will tell the investor if it's worth it to convert into the common stock, let's say the investor bought the preferred shares for $100 will. They probably don't want to convert into less than $100 of common stock. Would it make sense to originally by $100 preferred stock shares? And then convert it say into $60 of common stock.

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Probably not.

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Not a common stock market, price is going to be important for us to get to the answer. But so let's go ahead and look at the question again. What is the parity price of the preferred stock? Can certainly seem like a complex topic. But let's try the demystified real quick. The word parity basically means equivalent we're trying to figure out what is the equivalent price of the preferred stock. Assuming we're just looking at the conversion feature and yeah, that might sound a little confusing, but let's first and foremost, put up the formula up on the screen. The parity price of the preferred stock is equal to the market. Price of the common stock x x the conversion ratio. Now, of course, you can simply just memorize his formula, but let's talk about what exactly we're doing. What we have preferred stock that is convertible into 10 shares of common stock. So let's go ahead and plug that into the formula and the common stock is trading at $8 per share.

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It to the formula. We can think of our convertible preferred stock kind of like a pack of something. It's almost like we have a 10-pack of stock and we're trying to figure out what is the pack worth based upon the individual units in a pack. If we're looking at a 10-pack of common stock in each share of common stock is worth $8, a piece then are should be worth $80 over all. This is really no different than maybe some of the math you've done when you go shopping, what if you really like a shirt and you find a 10-pack of them? Well, if you think that each shirt is worth $8, then the pack to you is worth 80 bucks.

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We're not doing anything differently here. So of course our answer is a 80 bucks that is a parity price of preferred stock this type of parity price can certainly help you investor figure out if it's worth it to convert into Comic stock, the parity price of the preferred stock will tell them, what is the overall value of the comments. They can convert into

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Well, if we bought the preferred stock originally for a hundred bucks, and we can convert it into $80 a common stock.

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That might not make a bunch of sense and the investor probably would not convert in that example. Now, you might also know that there's another version of parity price. It's the parity price of the common stock. So let's go ahead and use basically the same information but slightly changed the question to what is the Perry price of the common stock? We will still have the same conversion ratio of 10 to 1 because nothing has changed in terms of the first two sentences of our question. The big change is what type of parity price were looking for? And there is a separate calculation for parity price, stock, the parity price of the common stock is equal to the market price of the preferred stock / the conversion ratio. If we're looking at this purely from the standpoint of the formula and we're pretty good at memorizing formulas. We can just plug in the numbers and figure out the answer. The preferred stock market value. Again is $105.

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The conversion ratio is 10 selfie take $105 / 10, we will get $10.50. And that certainly is our answer, which is see, but let's dive deeper into the meaning of this. And what does is actually telling us again? Let's think about the preferred stock like a 10 pack if I'm looking at a 10 pack but they have T-shirts again in the 10 pack is $105. If we were to do this math here, we would tell us what we're paying on a purse shirt basis, I buy the pack for $105, there's 10 units in the pack, so I'm basically paying $10.50 per shirt. Investors can also utilize this type of parity price to figure out if it's worth it again to convert into common stock.

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What's a the investor actually bought this preferred stock for $105? Again, if you take 105 / 10, we get $10.50, if they were to convert this into, stock, it's basically like they're paying $10.50 per share of common stock. So, when would the investor actually want to convert preferred stock in the comments. It's probably when the common stock will be trading above $10.50. For example, what if the common stock was trading at $12.50?

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Well, they could convert the preferred stock at attention as a common stock, sell that common stock at $12.50, and make a profit of essentially $2 per share. That would be a $20 profit. Overall, what's the question of the screen? And just look at the two parity price formulas. For our conclusion of this video, we have parity price of the preferred stock and parity price of the common stock memorizing formulas, alongside all the other things you need to know for these exams is definitely a tough thing to do, but sometimes we can look at these in a unique way and maybe we'll make it a little bit easier. To remember, let's look at the common themes, between both, parity price formula, both of them include the conversion ratio in the formula, okay? That's a valuable thing to know. You have to use a conversion ratio to get to the parity price. Always another unique thing about parity price is if we're looking for the parity price.

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One of the items being preferred a common stock, then we have to use the market price of the other thing in the formula. So, for example, if I'm looking for the parity price at the preferred stock, I'm going to use the market price of the common stock in the formula and vice versa. If I'm looking for the parity price of the common stock, I'm going to use the market price of the preferred stock in the formula and beyond that. The only difference is whether you multiply or divide one last nugget of knowledge, he might use an example. If you can't remember whether you should multiply or divide, you can try to recall this, whatever number you end up, with, in terms of the formula should seem like a number that relates to the product you're talking about. So, for example, if I'm looking for the Purity price of the preferred stock, if the preferred stock par value as 100, whatever number you get, there should be pretty close to a hundred with the parity price of the perverts.

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If you were to divide, instead of multiply, you would get a pretty low number it would probably be pretty far off any of the answers that they would give you. If you were to multiply instead of divided with the parity price, The Comstock, you get a really big number that probably would not seem terribly. Relatable to where the, sock was currently trading at or really any of the answers they gave you so worst case scenario, if you can't remember to multiply or divide, maybe that'll help you get to the right answer. All right? Hopefully that will help with your math base. Convertible questions that you go out there. Go to some practice questions. Try it on your own.

Tyler York

17 Nov 2022, 14 min read