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What is the Rate of Return on YOUR ESPP? {and is it too good to be true?}

By Josh Yeyni on Jun 10, 2010 in Microsoft Employees

As a financial adviser, I often ask my Microsoft clients: “What is the Annual (or Annualized) Rate of Return on your Employee Stock Purchase Plan (ESPP)?” Over the years I’ve gotten many answers to this seemingly simple question.

Actually, ESPPs are misunderstood by many employees.

The ESPPs have two major elements that contribute to the Rate of Return:
1. The discount on the purchase price offered by the company.
2. The capital gains or losses realized on the stock after the purchase date.

To answer the above question, let’s make the following assumptions:
1. The employee sells the stock purchased immediately so no capital gain or loss on holding the stock is realized.
2. We would ignore the tax implications of the immediate sale.
3. We would assume an ESPP with a 10% end-of-quarter discount.

Definitions from Wikipedia:
Rate of Return (ROR)
“In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested.

An annualized rate of return is the return on an investment over a period other than one year (such as a month, or two years) multiplied or divided to give a comparable one-year return. For instance, a one-month ROI of 1% could be stated as an annualized rate of return of 12%”.

When I ask employees about their ESPP, the most common answer is:

“The rate of return is 10%. We get a discount of 10% on the amount we purchase during the year”.

To arrive at the correct answer, we should refer to the definition above: Rate of Return (ROR)= Profit /Amount Invested.

Example: If an employee sells a stock for $30 that was purchased for $27 (90% of value) the gain is $3

ROR= $3/$27 =11%

If the quarterly ROR is 11%, than the Annualized ROR should be 11% X 4(quarters)=44%

This answer is NOT accurate either, because it does not account for the timing of the actual investments.

EXAMPLE:
Dan earns $72,000 annually and he is allowed to purchase $10,800 (15% of his wages) of his company stock during the year. Dan decides to purchase $2,700 per quarter and will have $450 deducted from each semi-monthly paycheck.

Quarter ended 3/31/YY

(Assuming $8 sales commission):

Average investment for the quarter = Investment$*Number of days/Number of Days in the quarter.

From 1/15 to 3/31 ——-$450—–75/90 = $375
From 1/31 to 3/31 —— $450—–59/90 = $295
From 2/15 to 3/31 ——$450—–44/90 = $220
From 2/28 to 3/31 ——$450—–31/90 = $155
From 3/15 to 3/31——$450——16/90 = $80
From 3/31 to 3/31——$450——-1/90 = $5
==================================
Total——————-$2700—————$1,130
==================================
Average investment for the quarter——- $1,130
Gain for the quarter = $292.00
(Sale of $3,000 less cost $2,700 less commission $8 = $292)

A much more accurate representation of the actual results is as follows:

QUARTERLY ROR > $292/$1,130= 25.84%
ANNUALIZED ROR > 25.84% X 4= 103.36%

CONCLUSIONS:

1. The discount offered by ESPPs provides a substantial profit to the participant with a minimal risk. Since the stock can decline in value, employees should decide if it is a prudent strategy to hold the stock after the date of purchase.
2. Selling the stock within two years from the date of grant, however, causes the discount to be taxed as additional W2 income. Employees should discuss with their financial advisers the strategies to mitigate the additional taxation.

Note:
We may need to consider any waiting periods (or “blackout” periods if any) before the employee is allowed to sell the stock.