Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal

November 17, 2006 by TFB

If you work for a publicly traded company which offers an Employee Stock Purchase Plan (ESPP), you've got yourself a fantastic deal. An ESPP typically works this way:

  1. You contribute to the ESPP from 1% to 10% of your salary. The contribution is taken out from your paycheck. This is calculated on pre-tax salary but taken after tax (unlike 401k, no tax deduction on ESPP contributions).
  2. At the end of a "purchase period," usually every 6 months, the employer will purchase company stock for you using your contributions during the purchase period. You get a 15% discount on the purchase price. The employer takes the price of the company stock at the beginning of the purchase period and the price at the end of the purchase period, whichever is lower, and THEN gives you a 15% discount from that price.
  3. You can sell the purchased stock right away or hold on to them longer for preferential tax treatment.

Your plan may work a little differently. Check with your employer for details.

The 15% discount is a big deal. It turns out to be a 90% annualized return or higher.

How so? Suppose the stock was $22 at the beginning of the purchase period and it went down to $20 at the end of the period 6 months later. Here's what happens:

  1. Because the stock went down, your purchase price will be 15% discount to the price at the end of the purchase period, which is $20 * 85% = $17/share.
  2. Suppose you contributed $255 per paycheck twice a month. Over a 6-month period you contributed $255 * 12 = $3,060.
  3. You will receive $3,060 / $17 = 180 shares. You sell 180 shares at $20/share and receive $20 * 180 = $3,600, earning a profit of $3,600 – $3,060 = $540.

Percentage-wise your return is $540 / $3,060 = 17.65%. But, because your $3,060 was contributed over a 6-month period, the first contribution was tied up for 6 months, and the last contribution was tied up for only a few days. On average your money is only tied up for 3 months. So, earning 17.65% risk free for tying up your money for 3 months is equivalent to earning (1 + 17.65%) ^ 4 – 1 = 91.6% a year.

90%+ a year return is fantastic, isn't it? That's when the employer's stock went down. Had the stock gone up from $20 at the beginning of the purchase period to $22 at the end, your return will be even higher at 180%!

[Update on May 30, 2008]: I created an online spreadsheet on Zoho. You can plug in your own numbers and calculate the annualized return. The annualized return is what a savings account will have to offer in order to match the same return from an ESPP. Even at 5% discount without lookback, an ESPP is still equivalent to a 20% APY savings account.

What should you do if your employer offers an ESPP? Participate to the MAXIMUM allowed as long as you can sell the stock soon after the stock is purchased.

Should you hold the purchased stock longer for preferential tax treatment? No! On the typical 6-month purchase program, you will have to hold on to the stock for additional 18 months in order to get preferential tax treatment. If everything goes well, you can reduce the tax on your profit from say 35% to 15%. In the above example, that will save you $540 * 20% = $108. But if your employer's stock goes down 3% during the 18 months you are holding the stock, because your entire $3,600 is at stake, the tax benefit will be completely wiped out. You already earned 90% annualized return on the purchase. Holding on for another 18 months and hoping the stock won't go down 3% is really penny wise pound foolish.

More technical details about ESPP on the web:

Software picked, likely related posts:

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Comments

17 Comments on Employee Stock Purchase Plan (ESPP) Is A Fantastic Deal

  1. Flexo on November 17, 2006 | permalink
    2.  

    Timely article. My company just began offering ESPP. The purchase period is three months, so there are 4 purchases each year, at a 15% discount of the price at either the beginning or end of the quarter. Our stock price is at the highest its ever been (IPO was in late 2001), but no matter what happens, it's an automatic 15% increase each quarter. I'll be investing the maximum 10% of my salary, and ofsetting the missing cash flow with savings each quarter. We can sell immediately, but I'm a designated employee, so I may have to way to until an open trading window is declared.

    I've written about it on my blog

  2. Adam on November 22, 2006 | permalink
    3.  

    This is an outstanding post. It's so good that I've quoted you liberally in a post on the same topic on my blog:

    Psychohistory

    I'm definitely going to subscribe to your feed.

    One minor nit. Your analysis on the "3 month average" is not quite right. You should do a discounted cash flow on the paycheck contributions, and then calculate the internal rate of return on the investment over the 6 months. When I did this (see my blog post), I got a 98.4% return, making the assumption that he got paid every 2 weeks.

    Thanks for the great post! Loved it.
    Adam

  3. TFB on November 22, 2006 | permalink
    4.  

    Thank you Adam for the compliments. With regard to the exact return, I didn't want to get too technical. After you understand the return is over 90%, it makes very little difference whether it's 91% or 98%. If you really want to be exact, you also have to take into account the 3-business-day settlement period and a typical $20 commission on the sale. For more fun with math, check out this post:

    TIPS Pricing Is Complex

  4. ricemutt on December 7, 2006 | permalink
    5.  

    Nice article. I wrote one a few months back on this exact topic, and it's interesting to see we have the same advice/approach. I've talked to many friends who don't seel until they can get preferential tax treatment, or do nothing with ESPP shares in their account at all.

    In my own personal experience, the companies who've offered ESPP have had big downside risks to maintaining their share price over 18 months' time. They're in some trouble, or they're high-growth stocks whose prices are fairly volatile, and all have been tech companies. Holding might work out sometimes, but to me, it's better to have the "free" money than risk it another 18 months or so.

  5. espp_in_cincy on February 23, 2007 | permalink
    6.  

    I have a question regarding ESPPs. The 15% discount, is that a form of reportable income or do you just get that margin for free? I read an article on compensation income and disqualifying dispositions and it is still unclear to me.

  6. TFB on February 23, 2007 | permalink
    7.  

    The discount is reportable income. Your employer will track it and add it to your W-2 if you sell right away. Read the Fairmark link for more details.

  7. Anonymous on June 14, 2007 | permalink
    8.  

    We disagree with your analysis.

    Your money is tied up for an average of 3 months (which is correct) – but you do not have the opportunity to purchase shares every 3 months – only twice per year.

    Also, you need to consider the opportunity cost of not investing the money at a risk-free rate alternatively.

    Shouldn't the calculation of return on an annual basis really be 1 + 17.65% ^2, ~ 38.4% before factoring opportunity cost and before factoring tax effects.

    I think you are overstating returns in your analysis above. That being said, ESPP's are still great deals.

  8. TFB on June 14, 2007 | permalink
    9.  

    The math is correct. You get this opportunity to earn 17.65% in exchange for tying up your money for 3 months. Even if you only get this opportunity once a year, the annualized return on the opportunity itself is still ~90%. The fact that you get to do this twice a year only means you get to earn ~90% annualized on more dollars. Adam in comment #2 said it should've been even higher at 98%. I made a spreadsheet for bi-monthly payrolls and I also added a $20 commission for the sale and 3 business days settlement delay. It came out to 87% annualized when everything is taken into consideration. You can look at the spreadsheet if you are interested.

    ~90% annualized versus risk free return of 5-6%, both taxable, I'd take the former any day. I wish I could do this on 100% of my salary.

  9. Anonymous on October 28, 2007 | permalink
    10.  

    Great article, very useful. I just started with a new company and learned about their ESPP. Instead of a 6 month purchase period, however, I've been told the stocks are bought monthly and contributions are met by the employer on a monthly basis by 25%. In this case, when would be the best time to sell?

    Thanks!

  10. Anonymous on December 26, 2007 | permalink
    11.  

    This math in this article is crap. ESPPs are excellent, but not for the reason quoted in the article. The 90% annualized return is ficticious and over-hyped (its even bolded and colored red to draw attention). It seems to be intentionally misleading (or even worse, unintentionally misleading). You may think quoting an annualized return is useful, but it is absolutely incorrect to apply it in this context. Using XIRR() and quoting the 90% return is reckless and dangerous to your readers.

    The fact is you get a 17.65% return after 6 months of investing. You can't arbitrarily say your money was tied up for 3 months on average and then annualize the 6 month figure by raising it to the 4th power! Furthermore, there is no compounding effect from ESPPs, you recontribute the next 6 months. At least use your math within the framework of the ESPP. The reality is that you get 17% return on half your dollars after 6 months, and then 17% return on a different half of your dollars, 6 months later. This equates to a 17% annual return.

    Imagine a 12-month CD with return of 5%. You can't say that on average the money was tied up for 6 months, and then use the year end 5% return to calculate an annualized return from the 6 month point! This would be like saying 1.05^2 is your annualized return .. but we already know the real annual return is 5%!

    To further prove my over-hyped point, assume a single payment of -$255 on 1/15/2007 that you can immediately flip on 1/18/2007 for $280 (with $17 cost, $20 sale, and $20 commission like your example). Using Excel's XIRR() on that produces an annualized return of 8746485%! Amazing right? Well not really .. it doesn't mean anything! I suppose it would be more credible if I colored it red and bolded it.

  11. TFB on December 30, 2007 | permalink
    12.  

    Time and the rate of return are related. If it takes 1 year to earn 5%, it's 5% rate of return per year. If it takes 10 years to earn 5%, the return is a lot less. Same with time frames shorter than 1 year. If it takes 3 months to earn 17.65%, the rate of return is a lot higher than what you'd earn if it takes one full year to earn 17.65%. With your CD example, if the CD allows you to deposit $100 a month and then gives you $1,260 at the end of the year, the return is a lot higher than a CD which asks for $1,200 up front and gives you the same at the end of the year.

  12. Anonymous on March 12, 2008 | permalink
    13.  

    I wonder if you can give an opinion on some tangled up issues with my ESPP. (I have totally screwed up by treating these shares as regular stock.) I've been transferring shares for several years into my son's ugma account (using gift-splitting with my spouse in some cases). I've only now realized that I need to declare income on the 15% discount for qualifying dispositions. Do I also need to declare a long-term capital gain at the time of gift? I thought the stepped up cost basis (original cost plus declared ordinary income) would be passed along to him as with typical gifts of stock. Thanks in advance for you help. I enjoy reading your blog.

  13. TFB on March 13, 2008 | permalink
    14.  

    Fairmark has very good writeup on the tax treatment of ESPP dispositions. Please note the two links in the end of that article with more detailed info on both qualified and non-qualified dispositions.

    Their book Consider Your Options covers both stock options and ESPP. It is an excellent resource.

  14. Anonymous on March 13, 2008 | permalink
    15.  

    Thanks. I actually had some communication with Kaye Thomas about my issue. Her site is a great resource; I think I will buy the book.

  15. Peter Answers on May 31, 2008 | permalink
    16.  

    It takes about a week for the shares to actually hit my account, and that week where your shares have been bought but you can't sell them define your risk window. I eliminate this risk by shorting the shares right away and then covering when the shares hit my account. It is lock solid, no risk, guarenteed return. As long as you are allowed to sell your shares right away, you are a moron for not taking out the absolute maximum you can. If you cant afford the money taken out of your check, borrow it.

  16. Miguel on October 6, 2008 | permalink
    17.  

    TFB – great article – I encourage my friends to take advantage of ESPP for just these reasons, even though our company has just changed things up a bit recently. We get a 15% discount off the period-end price only, no looking back to the start price anymore. That said, I've seen share prices fluctuate (ok, drop) dramatically just after the ESPP buy date, perhaps caused or aided by a flood of selling immediately after all my colleagues and I take control of new shares. I remember reading somewhere that companies with ESPP plans are supposed to buffer this effect somehow. Do you know anything about that?

  17. TFB on October 6, 2008 | permalink
    18.  

    Miguel – No I don't know anything about companies buffering the effect of employees selling shares acquired from ESPP. Depending on the trading volume of the company's stock, what employees sell can be a very small percentage of the overall volume even if all employees sell right away.

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