Warrants: Conversion Ratio

The conversion ratio determines the number of warrants required for conversion into one share of the underlying stock or one point of the underlying index at maturity.

For example, where the conversion ratio is 10:1, 10 units of warrants will be required to be exchanged for each share of the underlying stock.

Even for warrants with identical terms (same strike price, maturity and implied volatility), their prices may vary hugely.

These warrants are worth exactly the same.  Their prices vary in proportion to the difference in their conversion ratios.

The price of one may be a few cents while the other a few dollars.  This is due to their conversion ratios.

The bigger the conversion ratio, the lower the warrant price.



Conversion Ratio is Insignificant as a performance indicator

Psychologically, investors tend to prefer warrants with a lower face value.

After all, warrants of different price ranges do differ in tick movement.

In theory, the difference in the conversion ratio will not affect the price performance of warrants.

When you are picking a warrant, do not be bothered with insignificant data such as the conversion ratio or premium.  

Unless you want to hold the warrant until maturity, these data should not be a matter of concern.

Rather, to make sure that you are picking the right choice, you should check out carefully the other terms of the warrant, such as implied volatility and effective gearing.

(In calculating the value at maturity and the effective gearing of a warrant at any time, the conversion ratio is always taken into account.)

Measurement in the Balance Sheet

Book values measurement determines the price-to-book ratio. To evaluate the price-to-book ratio, we must understand how book values are measured.

The values of some assets and liabilities are easy to measure, and the accountant does so. He applies mark-to-market accounting, thus recording these items on the balance sheets at fair value (in accounting terms). These items do not contribute to the premium over book value.

But for many items, the accountant does not, or cannot, mark to market. He applies historical cost accounting. U.S. GAAP gives measurement rules for items commonly found on balance sheets, with those carried at fair value and historical cost indicated. International accounting standards broadly follow similar rules.

-----

Example:

Company A Balance Sheet

Cash and cash equivalent $7.764 million
Short term investments $208 million
Long term investments (mainly interest bearing debt securities) $1,560 million.

Comment:  A market value is usually available for these securities, so they can be marked to market.

Accounts payable $11,492 million
Long term debt $362 million

Comment:  The accounts payable is close to market value and, while the long-term debt is not marked to market, its book value approximates market value unless interest rates change significantly.

So all these items above do not contribute to price premium over book value.

Net accounts receivable $5,961 million
Financing receivables $1,732 million
Accrued expenses $4,323 million
Other "liabilities" $2,070 million

Comment:  All the above 4 items involve estimates, but if these are made in an unbiased way, these items, too, are at fair value.

Company A
2,060 outstanding shares
Market Price $20 per share.
Market value of these shares: $41,200 million.
Book value $3,735 million
Therefore the market premium was $37,465 million.

Comments:
The market saw $37,465 million of shareholder value that was not on the balance sheet.
And it saw $37,465 million of net assets that were not on the balance sheet.
With 2060 million shares outstanding,

• the book value per share (BPS) was $1.81 and
• the market premium was $18.19 per share.

How does one account for Company A's large market premium of $37,465 million over the book value of its equity?

The large market premium of $37,465 million over the book value of its equity arises largely from

• tangible assets, recorded at (depreciated) historical cost, and
• unrecorded assets.

The latter are likely to be quite significant. Company A's value, it is claimed, comes not so much from tangible assets, but from

• its innovative "direct-to-customer" process,
• its supply chain, and
• its brand name.

None of these assets are on its balance sheet.

• Nor might we want them to be.
• Identifying them and measuring their value is a very difficult task, and we would probably end up with very doubtful, speculative numbers.