If-Converted Method

What would have happened if Mary I had turned England back into a Catholic country? What if Charles Martel had lost the Battle of Tours? What if Tom Cruise had talked Madonna into being a Scientologist during the 1990s? All important "if-converted" questions.

There's also a connotation related to finance. It involves convertible securities.

Convertible securities allow the holder to exchange one form of financial instrument for shares of stock. You own a convertible bond paying 6% interest with a 5-year maturity. Under certain circumstances, you can also turn the bond into 1,000 shares of common stock.

That situation describes the type of "conversion" we're talking about here (sorry, Mr. Cruise). Meanwhile, companies report some of their financial results on per-share basis. In fact, the chief statistic for determining a company's financial health is often its earnings per share, or EPS.

Generally, the math behind EPS is pretty simple. Take the firm's net earnings. Then divide that figure by the number of shares outstanding. The result: earnings per share.

However, that second number (the shares outstanding) gets muddled by convertible securities (among other things, like stock options). As it stands now, those shares don't exist. So they wouldn't get counted in the EPS figure. However, they could exist at any time, especially if the convertible securities are in the money (the stock price set forth for conversion is below the current market price for the stock, making it profitable for someone to exercise the option).

Let's take a slight detour to give an example of the type of conundrum we're talking about. You win the lottery and you want to share the winnings with your family. So that no one feels bad, you want to give every member of the family the same amount. You have your parents, your brother, your brother's wife and their two kids.

However, your sister-in-law is currently pregnant. How should you split up the money? Does the kid currently in utero count? Right now the split would take place between 6 people (your mom, your dad, your brother, your sister-in-law, and each of their two currently air-breathing kids). But that third child will be here soon.

If you use the if-converted method, you'd count that third kid.

The if-converted method considers what would happen if the company's applicable convertible securities were turned into stock. It provides an EPS figure taking into account what would happen if those shares were created.

Usually, companies will provide two EPS figures. One includes just the currently outstanding stock. The other, usually called "diluted EPS," describes what EPS would look like if all the conversions and stock options and other stock-creation devices were exercised.

Investors usually look at the diluted EPS figure as the definitive judge of the firm's earnings situation.