Common Stock Equivalent
The term common stock equivalent is used to describe a wide variety of securities and agreements that provide the holder with the right to receive or acquire common stock. Common stock equivalents can include securities such as stock options, warrants, grants, preferred stock, bonds, and contingent shares.
The value of these equivalents will often change with the market value of the company’s common stock. These securities can also have a dilutive effect on the company’s earnings per share.
Companies issue common stock to raise capital. Purchasing shares of common stock typically provides the investor with the right to vote on certain corporate issues, share in the ownership of the company, and receive dividends. Generally, a common stock equivalent can fall into the following two categories:
- Convertible Securities: includes preferred stock and bonds issued by the company that provide the investor with a conversion feature. These investments carry this feature to add to the marketability of the underlying security. Investors value preferred stock and bonds containing this feature because it provides them with the ability to enjoy the benefits of common stock without owning the security.
- Employee Stock Option Plans: includes restricted as well as unrestricted stock options in addition to warrants and grants. These incentive compensation plans provide the employee with the opportunity to purchase shares at a discount or free of charge.
Once a security is classified as a common stock equivalent, it is used in the calculation of primary earnings per share if the securities are dilutive. Certain securities, such as convertible bonds, can be antidilutive and actually increase earnings per share.
Typically, a security would be classified as a stock equivalent when the market price per share is higher than the security’s conversion price. When this occurs, the security will trade as if it’s an equity issue, and its price will move in-step with the price of the common stock.