Introduction
Convertible securities and warrants occupy a gray zone between debt and equity, and their treatment in valuation requires careful analysis to avoid the most dangerous error in valuation: double-counting. These instruments give the holder the right to convert into common equity at a predetermined price. Whether they are treated as debt (in the EV bridge) or equity (in the diluted share count) depends on whether conversion is economically advantageous.
For a detailed discussion of how convertible bonds work, see our blog post on convertible bonds.
The Conversion Decision
A convertible security is in-the-money when the value of the common shares the holder would receive upon conversion exceeds the face value of the security. A $100 million convertible bond with a conversion price of $50 per share produces 2 million shares upon conversion. If the stock trades at $75, the conversion value ($150 million) exceeds the face value ($100 million), and conversion is likely.
When a convertible is in-the-money, the holder will rationally choose to convert, so the analyst should treat it as equity. When it is out-of-the-money, the holder will keep the bond/preferred and collect interest/dividends, so the analyst should treat it as debt.
- If-Converted Method
The valuation treatment for in-the-money convertible securities that assumes all convertibles are converted into common shares. Under this method, the convertible instrument is removed from the debt (or preferred equity) line in the EV bridge, and the resulting shares are added to the diluted share count. The interest expense (or preferred dividends) associated with the converted instrument is also removed from the income statement when calculating pro forma earnings for valuation multiples.
Treatment in the EV Bridge
| Scenario | EV Bridge Treatment | Share Count Treatment |
|---|---|---|
| In-the-money convertible bond | Remove from debt | Add conversion shares to diluted count |
| Out-of-the-money convertible bond | Include as debt | No shares added |
| In-the-money convertible preferred | Remove from preferred equity | Add conversion shares to diluted count |
| Out-of-the-money convertible preferred | Include as preferred equity | No shares added |
| In-the-money warrants | N/A (warrants are not in the bridge) | Add net shares via TSM |
| Out-of-the-money warrants | N/A | No shares added |
Warrants vs. Options
Warrants function similarly to stock options but are typically issued by the company (rather than granted to employees) and have longer maturities (3-10 years vs. 1-4 years for employee options). They are diluted using the treasury stock method: assume exercise, calculate proceeds, assume repurchase at market price, and add only the net new shares.
Unlike convertible bonds, warrants do not appear in the EV bridge because they are not debt instruments. They affect the diluted share count only.
Net Share Settlement
Modern convertible bonds increasingly include a net share settlement provision: the company pays the face value in cash and issues shares only for the in-the-money portion. This significantly reduces dilution compared to full physical settlement. Under net share settlement, the analyst adds only the incremental shares above the face value, not the full conversion shares. This is a modified TSM calculation that produces less dilution.
Capped Call Structures: Modern Dilution Management
The convertible bond market has experienced a resurgence in 2024-2025, with global issuance reaching $80.1 billion in H1 2025 alone (the strongest first half since 2021), driven by the high-rate environment making convertibles attractive to issuers seeking below-market coupons. A growing number of these issuances include capped call derivatives that directly affect the dilution analysis.
A capped call is a derivative contract between the issuer and a bank counterparty that offsets dilution above the conversion price up to a specified cap price. If a convertible has a $50 conversion price and the capped call has a $75 cap, the company is protected from dilution between $50 and $75 (the counterparty delivers shares or cash to offset the dilution in that range). Above $75, dilution resumes. The capped call effectively raises the "effective conversion price" from $50 to $75, reducing dilution significantly at a cost of approximately 5-10% of the bond proceeds.
For the analyst building a dilution schedule, the capped call changes the calculation: instead of modeling dilution from the stated conversion price, the effective dilution threshold is the cap price. If the stock trades between the conversion price and the cap, the company has no net dilution (the capped call offsets it). Only above the cap does dilution begin. This is increasingly important because a significant portion of new convertible issuances in 2025 include capped calls, and ignoring them overstates the dilutive impact.
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