If-Converted Method

The If-Converted Method is a calculation used to determine the potential impact of convertible securities on a company's earnings per share (EPS). Think of it as a “what-if” scenario that answers a critical question for investors: “What would our earnings per share look like if all the special securities that could become common stock actually did?” These special securities, such as convertible bonds or convertible preferred stock, give their holders the right to swap them for a set number of common shares. The if-converted method assumes this conversion happens. This increases the total number of shares outstanding, which typically waters down, or “dilutes,” the EPS. The result is a more conservative and often more realistic picture of a company's profitability, forming a core component of the diluted EPS calculation.

For a value investing practitioner, understanding the if-converted method isn't just academic; it's a crucial part of risk assessment. It helps you look beyond the headline earnings number to see the underlying reality.

Value investors hate negative surprises. One of the nastiest surprises is finding out that your ownership stake in a company has been shrunk by a flood of new shares. The if-converted method acts as an early warning system. It reveals the “shadow” supply of shares waiting in the wings from convertible instruments. A company might report a rosy basic EPS, but if there's a huge number of convertible securities outstanding, the diluted EPS calculated via the if-converted method will be much lower. This gap is a red flag, signaling that your slice of the company's profit pie could get significantly smaller in the future.

Value investing is built on a foundation of conservatism and a healthy dose of skepticism. The if-converted method aligns perfectly with this philosophy by stress-testing a company's earnings. It forces you to consider a less-than-ideal scenario where the share count swells. If a company still looks attractively valued based on its fully diluted EPS, you are making a decision based on a much more robust and cautious assessment. It's important to note that this method is only applied if the impact is dilutive (i.e., it lowers the EPS). If assuming conversion would actually increase EPS (a rare situation), these securities are considered antidilutive securities and are excluded from the calculation for that period.

Let's imagine a company called Durable Widgets Inc. and see how the if-converted method works. Company Data:

• Net Income: $2,000,000
• Common shares outstanding: 1,000,000
• Convertible Bonds: $1,000,000 in face value, paying 5% interest. Each $1,000 bond can be converted into 20 shares of common stock.
• Corporate Tax Rate: 20%

Step 1: Calculate Basic EPS This is the simple calculation before considering any dilution.

• Basic EPS = Net Income / Shares Outstanding
• Basic EPS = $2,000,000 / 1,000,000 shares = $2.00 per share

Step 2: Apply the If-Converted Method to Find Diluted EPS We need to adjust both the numerator (earnings) and the denominator (shares).

1. Adjust the Numerator (Net Income): If the bonds were converted, Durable Widgets wouldn't have to pay interest on them. We must add back the interest expense, but after accounting for the tax savings it provided.
   • Annual Interest Expense = $1,000,000 x 5% = $50,000
   • Tax Shield from Interest = $50,000 x 20% = $10,000
   • After-Tax Interest Savings to Add Back = $50,000 - $10,000 = $40,000
   • Adjusted Net Income = $2,000,000 + $40,000 = $2,040,000
2. Adjust the Denominator (Shares Outstanding): We assume the conversion happens and calculate how many new shares would be created.
   • Number of Bonds = $1,000,000 Face Value / $1,000 per bond = 1,000 bonds
   • New Shares from Conversion = 1,000 bonds x 20 shares/bond = 20,000 new shares
   • Adjusted Shares Outstanding = 1,000,000 + 20,000 = 1,020,000 shares
3. Calculate Diluted EPS:
   • Diluted EPS = Adjusted Net Income / Adjusted Shares Outstanding
   • Diluted EPS = $2,040,000 / 1,020,000 shares = $2.00 per share

In this specific case, the diluted EPS is the same as the basic EPS, meaning the bonds are not dilutive under these conditions. If the result had been lower than $2.00, it would have revealed the true, diluted earnings power of the company.

The if-converted method is a tool for financial prudence. It helps you peel back the layers of a company's capital structure to understand its true earning power on a per-share basis. For the intelligent investor, ignoring potential dilution is like sailing without checking the weather forecast. By always using diluted EPS as your guidepost, you ensure you are investing with your eyes wide open, protecting yourself from future dilution and making decisions based on a more conservative—and safer—reality.