Friday, April 13, 2007

Employee Stock Purchase Plans: Free Money, No Risk

Yesterday I wrote a post about the pros and cons of investing in your own company stock. My conclusion is that investing in your company stock is a serious financial mistake. However, this rule has at least one major exception: employee stock purchase plans (ESPP).

Many publicly traded companies offer their employees the chance to purchase company stock at a discount. The program typically requires that employees designate a percentage of their after-tax income, which is automatically deducted from their pay check. The money accumulates for a certain period of time, at the end of which it is used to purchase company stock.

Under the terms of my wife's ESPP (at her old company), an offering period would start and end twice a year: Feb 1 and Aug 1. The 15% discount would apply to either the price of the stock at the begining of the offering period or the end of the offering period, whichever was lower. For example, if the price on Feb 1, 2006 was $10 and the price at the actual purchase date on Aug 1, 2006 was $12, you would pay $8.5 per share: 15% below the Feb 1 price. You are guaranteed a 15% return on your money, you have absolutely no risk, and your upside is unlimited. What is there not to love about this program?

Readers who have read yesterday's post understand that I am very much against investing in your own company stock, and true to form the strategy we used with my wife's ESPP was to sell the stocks immediately upon purchase, take our minimum 15% gain and use the money to buy index funds.

Of course, to calculate your real profit you need to take into consideration the opportunity cost of having the cash locked up in the ESPP for three months on average, and factor in the short term capital gains tax which you have to pay on the profit from selling the shares. Even when these are taken into account there is still a large amount of free money involved. If anyone asks, I'll be glad to share the calculation in a comment to this post.

Another benefit of our ESPP strategy is that it is a forced, regular savings plan. The money is deducted directly from your salary, and if you start the program as soon as you join the company, the money never appears on your pay check, so you do not miss it. That money adds up pretty quickly, and twice a year you get a very nice, tidy sum deposited directly into your brokerage account.

In summary, if your company offers an ESPP that includes a discounted stock price, take advantage of it. My advice, however, is to not be tempted to hold on to the stock once it is purchased in the hope that it will appreciate further. Sure, the stock may go up. It can just as easily go down. Sell your discounted stock as soon as you can and use if for a more diversified investment.


Living Almost Large said...

We max ours out and learned a good lesson in November when we lost money based on DH's "feelings". Sigh I no longer listen to him and decided that he's just uber confident for the wrong reasons. Also how we lose money in stocks, but I guess better we learn now than later.

He'd never admit it but I was right. Life is easier in index mutual funds. Boring but reliable.

Anonymous said...

Kindly post the calculation

Jenifer said...

This is very niche and excellent content love to see more post like this..keep posting. Thanks for information ..bravo...

Josh Maher said...

ESPP definitely has a place in every portfolio, I would say that selling covered calls against the ESPP is better than flipping the stock. Higher average returns and better tax treatment!