# Your Employee Stock Purchase Plan (ESPP) is Worth a Lot More Than 15%

First, credit for this article goes largely to “The Finance Buff“, a great blog I just discovered today. He wrote a post about Employee Stock Purchase Plans (ESPP) that really struck a chord with me, and I thought I’d share it with my readers.

Employee Stock Purchase Plan (ESPP) Is A Fantastic `Deal`

Most people think of their ESPP plan as a nice little perk. But after running the numbers, it seems like it’s a much better return that people give it credit for. It’s definitely a much higher return, on average, than the 15% number that people tend to gravitate to.

Let’s walk through the highlights of why by walking through the original post. First, he defines the basics of what an ESPP plan is:

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.

OK, so that covers the basics. I have seen minor variations on the above, but nothing that eliminates the math that he is about to walk through:

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%!

I think the reason people focus on the 15% is a classic example of why people, even very educated people, are not very good intuitively at dealing with money. 15% feels like the value of the ESPP program, because that is the “cash on cash return”, as we used to describe it in venture capital.

Let’s take the example of a hypothetical engineer, Joe, who makes $85,000 a year working for Big Tech, Inc. Joe is a saver, and as a result he puts 10% of his salary into his ESPP plan. Over the course of the period, the stock goes nowhere. Big Tech shares are always worth $50.

At the end of six months, Joe has contributed $4250 to his ESPP plan. They take the lower of the two stock prices, which are both $50, and set the price at 15% lower, $42.50 per share. (You can tell that I used to be a teacher… my numbers are suspiciously turning out to divide out evenly…)

$4250 buys 100 shares at $42.50 each. Since you got a 15% discount, people think that you got a 15% return.

**Wrong.** A 15% discount actually means you got a 17.65% return. (Read that line again). You have stock worth $5000. But you only paid $4250 for it, for a gain of $750. $750/$4250 = 17.65%.

This isn’t some sort of numbers trick – it’s actually just the difference between looking at what discount you got off full price (15%) versus the return on your money that you received (17.65%). Percentages going down are always more than percentages going back up. For example, if you got a 50% discount on a $1000 TV means you only have to pay $500. But if they raise the price from $500 to $1000, that’s a 100% increase.

So that’s the first gotcha. And 17.65% is nothing to sneeze at. That’s better than the historical average return of every easily accessible asset class I know of (I am excluding Private Equity & Venture Capital, since most people do not have access to them.)

The second gotcha is the fact that Joe didn’t just give them $4250 one day, wait six months, and then got $5000 back. He actually paid it in gradually, paycheck by paycheck. So, he didn’t get a 17.65% annual return.

Now, this is the place where I’ll get technical and explain that Joe didn’t get 17.65% return over 3 months either… that math is faulty. To calculate this correctly, you need to do a cash flow analysis where you evaluate the internal rate of return taking into account each paycheck that Joe made.

In fact, using the numbers provided in my example, I get an annualized return of **98.4%** for Joe – and that’s for a stock that didn’t go up!

Salary: $85,000.00

ESPP: 10%

Paychecks/Year: 26

1/14/06 $(326.92)

1/28/06 $(326.92)

2/11/06 $(326.92)

2/25/06 $(326.92)

3/11/06 $(326.92)

3/25/06 $(326.92)

4/8/06 $(326.92)

4/22/06 $(326.92)

5/6/06 $(326.92)

5/20/06 $(326.92)

6/3/06 $(326.92)

6/17/06 $(326.92)

7/1/06 $(326.92)

7/1/06 $5,000.00

**IRR 98.4%**

So, I think the lesson here is pretty clear. The biggest problem with ESPP programs is that you can only contribute up to 10% of your salary to them, typically. Otherwise, it would make sense to take out almost any type of loan in order to participate. You’d easily be able to pay it back with interest.

However, be forewarned. All of this analysis assumes that you will sell your stock the day you get it. It also is a “pre-tax” return, since you own income taxes on the $750 gain the day your ESPP shares are purchased.

**Disclaimer:** I am not a financial professional, and every personal situation is different. This blog is personal opinion, not financial advice. You should thoroughly investigate and analyze any financial decision yourself before investing any money in any investment program.

**Update (11/10/2007): ** There has been some commentary that questions the IRR calculation for this example. I’ve uploaded the Excel spreadsheet for this example. It shows that for this series of cash flows (13 negative, 1 positive) that the IRR is 98.4%. For this spreadsheet, I use the XIRR function, which is part of the Excel Analysis Toolpack Add-on, which handles IRR calculations for non-periodic cash flows.

From Excel Help:

XIRRreturns the internal rate of return for a schedule of cash flows that is not necessarily periodic. To calculate the internal rate of return for a series of periodic cash flows, use the IRR function.

Thanks for the explanation. I have to admit that I always thought about it as a minimum 15% return, but it’s quite obvious that I hadn’t thought about it enough. :)

Of course, all the advice about selling it the day you get it presumes that there’s not much of a chance that the stock will substantially increase in value. I sure wish I’d kept my ESPP shares from when Apple stock was around $13….

Hi Eric,

Of course, if you think a stock is going to go up significantly in value, you might want to keep it. But at that point, it’s no different than just buying the stock on the open market at that price.

You are saying you wish you had kept your ESPP shares from when Apple was $13… (I remember my ESPP grant from Apple in 1996 was at $11.75, and that’s 2 splits ago). But I think what you are really saying is, “I wish I had bought more Apple when it was at $13).

Usually people are over-concentrated in their employer, so it doesn’t make sense to own more company stock. But individual situations can vary.

Thanks for reading!

Adam

I’m with you on the difference between the 15% and 17.65%. But you lost me when you jumped to 98.4%. How does the frequency of payments matter if the overall amount invested over the year is still the same?

Frequency (timing, really) of payments matters, because each dollar socked away in the ESPP bucket prior to the actual purchase date still gets to buy at the same 15% discount.

That is, your first dollar had to wait 6 months in order to get a 15% discount, and your last dollar contributed only had to wait 1 day in order to qualify for the 15% discount. If you could only control one of these dollars, which would it be? If you think about it, you’d want to own the last dollar, since you could have been investing it in other things for the prior 6 months, earning additional interest.

Time has value when it comes to investments, so the fact that your contributions are staggered evenly throughout a 6 month period makes each contribution more valuable, as each contribution to the ESPP boosts the overall rate of return you’ll experience.

Another way to think of it is to assume you could make the entire contribution of $X,XXX on the last day of the 6 month window. That would be the best return, since you could make the same gain overall while only tying up your money for a single day — awesome ROI….but, same $ return you say? Not if you were investing all that money in another asset up to the point you contributed it in the ESPP.

My plan is vastly different so be careful before believing that this is such a great return. I did our ESPP and bought 225 shares of my company stock. The way they did it for me was “Loan” me the money up front to buy the stock and pay off the loan over a 4-year period. This was the only way I could get the stock as a paycheck deduction. They gave me 10% of the price. I have contributed 3000 dollars into the plan so far from my paycheck. The stock cost me 10,000 dollar loan at the 10% discount which meant the instant value was 11,000 at the loan inception. SInce I bought our stock though our company’s price has dropped about 20%. I am quitting my job soon in the next two weeks and had to cash out my stock purchase. My company sold the stock at value to pay off the remainder of the “loan” which had a balance of 7400 because of interest. The stock though i originally purchased is only valued at 8400 now. This means I am only getting 1000 cash back. I have put 3000 dollars though into my ESPP. This means I have an approximate 66% realized LOSS on the value of the stock I was supposedly purchasing each paycheck. A much different scenario then the one above. Just thought I would share because I couldn’t imagine this would happen since my company is Fortune 500 company with no debt and a low p/e ratio but it did. Now I am stuck with a 2000 dollar loss which isn’t that much in the grand scheme of things but as I am in my early 20s represents a significant amount of my small portfolio.

I have ESPP. but the deduction is after tax. but the 401 k is before tax. So when you consider the 401 k contribution is more ( your suppsedly tax money is also growing), whic one is better?

Thoughts?

Rregards giig

Hi Gigi,

They shouldn’t be mutually exclusive. Because with ESPP you get all your money back after 6 months, you should be able to do both ESPP & 401K. Only the 401k locks your money up for a long time. It may take some cutbacks on expenses, but the right thing to do is to do both.

If I was forced to choose, I would say always do the 401K up to get the maximum company match. Very often, this is an immediate 100% return.

I would them max out ESPP, and after the 6 months, I would use the money to step up investment in my 401K and/or Roth IRA, depending on your situation.

Adam

Hi,

I just came accross your site while looking up some info on ESPP, and I’m sorry to say there’s a serious flaw in your argument concerning IRR. The problem is, you’re treating this as though it were a compounding interest problem when in fact each period is discreet. That is, you save up X amount per period and execute the buy and the sell. The money you invested in the first period is not carried over to the following periods and is thus not relevant to what happens in the subsequent periods. Consequently, the actual IRR is really just the IRR for each of the periods.

Additionally, you should factor in that ESPP escrow accounts do not earn interest. Therefore, you’re potentially loosing the compounding growth of those moneys. If you assume a MARR of 8%, that 17% IRR goes down to around 12%

Finally, just a look at the numbers should have told you that something was wrong…you’re claiming an IRR of 98%. To get a that, one would have to almost double his money every year just by doing the ESPP transaction…surely you see that’s not the case!

Now I agree with you that ESPP is a nice investment tool…12% IRR relatively risk free is nothing to snease at, but it is nowhere near the windfall you incorrectly claim it to be. If you don’t believe me, please take your numbers to a financial advisor and see what they have to say.

Hi Mark,

You are completely wrong. The IRR is 98.4% in the case I cited above. I think you are confusing the definition of IRR, which is an internal rate of return based on the actual cash flow time periods and an annual ROI, or annual return on investment.

It does not matter that the money you put in an ESPP does not compound or earn interest. Every paycheck, you make an “investment” in your ESPP, with a single large payout at the end.

As a result, the implicit “return” on each paycheck is different from an IRR perspective. The first paycheck sits in the account for 6 months to get its 15% discount, the last paycheck only sits for 2 weeks.

The fact that you can’t re-invest that money at that rate is not relevant for the discussion of IRR. It is relevant for the discussion around ROI. You obviously don’t double your money with ESPP.

But, it is a FANTASTIC IRR, and one people should take advantage of.

Update:

Because of ongoing confusion caused by Mark’s comment, I’ve updated the post with a link to an Excel spreadsheet that I used to generate the original numbers for the post.

The 98.4% number comes from the XIRR function in Excel, which is utilized to calculate the correct IRR for a set of non-periodic cashflows.

Thanks.

Adam

Without having the addon tool for excel, I have attempted to recreate your 98.4% using the IRR function and find that the IRR value come out to 2.3%. Any thoughts.

Hi Jason,

The Analysis Toolpak comes with Excel – you just have to enable it in the Add-Ons menu.

In any case, IRR & XIRR are totally different functions, so my thoughts are that you are using the wrong function in this case.

Solving for IRR is a very complex mathematical equation for anything more than a trivial cash flow. In this case, you have 14 cash amounts and dates to deal with. IRR makes a number of trivial assumptions to reach its conclusion, mainly by ignoring the date entirely, and assuming the sequence happens over equidistant periods, and ignores annualization.

XIRR uses an interative approach to solve the non-linear equation, using each date specifically for the cash flow. It is the right function to use in this case.

My guess is that besides using IRR, which is incorrect in this case, you also may be providing a poor “guess” to the function (the second parameter). These equations tend to have multiple answers/solutions. (in fact, a polynomial with 15 terms potentially may have 14 different zeroes), so with a default guess of zero, you are getting 2.3%.

Hope this helps.

Adam

I’m with Mark on being dumbfounded at the 98% figure. Seriously, how is the money doubled? Also, sometimes you need to do the math yourself or know the equations instead of pushing a button in some Microsoft program.

Mark & I discussed over email, and he now understands the math and the analysis.

The reason you are “dumbfounded” is because you are misunderstanding the meaning of an IRR in the first place. An IRR of 98.4% does not mean the money doubled. The IRR is a blended return of the entire cash flow, and is very sensitive to the dates of each investment.

Look at it this way. For the $326.92 that you invested on January 14, it took almost 6 months to earn 15%. If you can earn 15% on your money every 6 months, that works out to an annual IRR of 32.25% (1.15^2 – 1).

But, you also earned 15% on the $326.92 that you invested on June 17th. In that case, you earned 15% in just 2 weeks! If you annualize that IRR, then you get 3686% (1.15^26-1).

When you annualize IRRs, compounding really matters.

The XIRR function is able to calculate the result of a multi-term polynomial that represents all 13 of the investments, plus the single positive outcome, in a mathematically correct blended IRR for the entire stream. That’s why you get 98.4%.

It does not mean your money doubled.

Note – if you play with the dates on the spreadsheet, you will get different numbers if you change any of the inputs by even 1 day. For example, if I make the last payment on 6/30 vs. 7/1, you get a lower number.

The point of this post was to illustrate the correct math, versus the math of the blog I was reading that day.

I have solved enough large, non-linear polynomial equations in my time to have faith in the XIRR function in Excel, when used properly. I also frequently use a calculator to multiply numbers, rather than doing it by hand.

If you are interested in this math, you should research online the basic mathematics of calculating returns on cash flows.

Adam

Hi Adam,

Thanks for publishing this analysis it has been an eye opener. I have two variations on the theme and would be grateful if you could analyze them.

First, my company’s ESPP cycle is 3 months (not 6). My guess is, this would result in an even greater IRR because the money is tied up for a shorter period of time – true?

Second, I wonder about a variation that takes into account the fact that taxes on gains will be lower if stock is held at least one year. Suppose I always sell after 366 days. This means that during the first year, I tie up my money longer, but in subsequent cycles, I basically keep selling as much as I buy. Could this mean I will suffer a lower IRR only in the first year (i.e. initial investment), but will attain 98% thereafter? Or does it mean that, realizing I would have 9-12 month’s worth of money tied up at any point in time (in the above mentioned 3-month ESPP cycle) I would screw up the whole IRR scheme by trying to save on taxes?

Thanks,

Dan

Adam I’d love to hear your thoughts on Dan’s 2 questions above as well.

Thanks!

Dan, Ian:

Your assumption is correct. When I adjust my spreadsheet for a 3 month time period, the IRR jumps to over 300%. Getting a 15% return in just 3 months is huge, so the effects are magnified exponentially from the 6 month case.

I haven’t run the calculations based on taxes, because there are so many complexities when it comes to tax code. Once you let the investment ride with the ups & downs of the market, it’s a very complicated analysis to figure out, on average, whether you are better or worse off, risk adjusted, waiting for the lower tax rate.

If you leave the money tied up for an extra 12 months, then apples-to-apples, the IRR will be much lower. Part of the reason the IRR appears so high is because that last paycheck contribution is only held up for two weeks.

Hope this helps.

Adam

Adam,

I am curious as to when an employer actually purchases the shares & how is the employer guaranteed market closing price? Do they purchase the shares in advance or during entire 6 month cycle?

For example:

(6 months cycle):

starting price:120(01/01/08)

ending price:100(06/30/08)

Employer purchase price:100.

Employee purchase price:85(15%)

In the above case, did the employer buy the shares from open market on 06/30/08 at 100. If so, how? The price could have varied all day before it closed at 100.

Patil,

I am not 100% sure, but I believe that ESPP programs are allocated out of a pool of stock already owned by the company, so there is actually no market transaction, just a transfer of ownership. They use the market price at end of day as an arms-length value to ensure fair pricing.

So there is no possibility of disconnect.

Adam

Hi Adam,

I just wanted to add a counter-point to this article. It’s a few days (years?) late, but Google never sleeps. :)

I consider it a bit disingenuous to use “IRR” in this situation. If you consider cash flows for the period in question (1yr), every “investment” made into the ESPP is getting a literal 17.65% cash return.

After the 6mo’s is up, each penny invested is now worth 1.1765 of itself* (*plus interest). After the end of 1 year, every penny is still only worth 1.1765+interest. Timing does not apply because you have to consider each investment as the start of a single 1-year period.

It doesn’t matter that my last paycheck gets its 17.65% in only two weeks; because after 1 year’s time, the actual return is still only 17.65%+interest.

Let’s do a true example year. In a 1-year period (starting from date of first deduction), you will have invested 4250*2=$8500. The first return gives you $750, plus 6mo’s interest (5%/2) on the whole balance. The second return gives you 750. That’s total cash-flows of 10,125.

So, $1625 in new cash earned in a 1-yr period. With 8500 used to get that, that’s 19.12% actual annual return.

This is the actual, valid, annual rate of return that someone can expect in this ESPP situation. This is what people should consider when deciding to invest in their ESPP. After 1 year (or better, 2 years, the usual offering period) of investing in their ESPP, they will still only be getting an actual annual return of 15%-20% (plus price volatility gains).

- DaftShadow

Hi DaftShadow,

You make some valid points, but in the end, IRR is the only way to value the time-value of money, and in this case, the time-value matters a lot.

If you re-read my post, I do, in fact, state that 17.65% is the number that you might expect with a purely cash-on-cash basis. You’ve done two sequential periods to get an annual number, and that’s fine.

However, it matters that you don’t put all the cash up front. If you had the choice to put all the cash up front, vs. leaving some of the investment to the last two weeks, you would take it. And that’s because, in reality, this isn’t a single investment, it’s 13 sequential investments.

IRR is the correct mathematical way to represent this, so I stand by the 98.4%. Your point is of course valid, however, to illustrate to people reading this article why IRR is not the same thing as a total return.

Adam

Is there ever a time when the ESPP doesn’t make sense? For instance, if you sell the shares “early” it’s a disqualifying disposition. You can either have W-2 income and a short or long term capital gain or W-2 income and no gain ( stock dropped ). In either case, the dollars you have at the end are more or less than if you had just saved the money in your checking account ( 0% interest )? Thanks.

Yes, there are a *lot* of situations where an ESPP wouldn’t make sense:

1) If you can’t afford the liquidity loss (10% of salary)

2) If the time between when you get the shares and when you can sell them (due to black out periods) is long enough, the stock can drop in the interim

3) If buying the shares triggers a wash sale issue for you taking a loss otherwise on shares you’ve purchased

This is just off the top of my head. (1) and (2) are the most common. My analysis really assumes a flat stock, where the delta between the time you get the shares and the time when you can sell has no effect on price.

Adam, thanks for this article. Based on my experience, I would add another category when ESPP doesn’t seem to make sense – when the stock value is very low, and the discount is low. For example my company’s stock value is about $3, and the discount is only 5%, not 15%. The stock stayed stable, but the discount doesn’t even cover the $20 brokerage fees to sell what I’ve purchased.

Quite significantly precised and informative,.. Thank you for sharing this info,..keep it up!…

what you are saying is that on 10% of your income you can get a 100% return every year, if you flip your ESSP immediately.

Thats a 10% raise right?

Unfortunately, no. Don’t confuse IRR (an internal rate of return) with ROI (return on investment). The IRR is high because some of the money goes in for only two weeks (you put some aside every paycheck). But overall, the ROIC is much lower on a dollar in / dollar out basis.

Wow. At Oracle, you only get a 5% discount off the purchase price and the purchase price is not the lowest of the starting and end dates, but the end date. Period. Because of this, it’s hard for me to understand if there is any reasonable point to it at all. Since a stock can easily drift 5% or more in a single trading session, I could just as well buy the stock on my own on, say, June 1st as opposed to letting my company buy it for me on June 1st.

Employee stock purchase plans are when your employer has offered you the opportunity to buy stock in the company that you work for. Not only are you potentially going to earn a profit but you get to purchase these stocks at a discounted price because you are an employee.

So, since an atomic ESPP transaction is described as 5-15% discount over 3/6 months why would anyone care about X/IRR over a flat stock when the real indicator is the ROI that’s not dependent on stock fluctuations?

Most people think about ESPP on a cash in, cash out basis. Example: I’m going to put in $3000, and get out at least $3450. The XIRR indicates that actually, it’s much better than that, because you don’t have to put the $3000 in up front, but you get to pay it incrementally. Liquidity matters.

Hi Adam,

I have a question for you regarding my specific ESPP. Here are the details:

- I can contribute up to 15% of my base salary to the ESPP;

- Stock is purchased on the last day of EVERY MONTH, at the high-low AVERAGE on THAT DAY.

- I receive the same 15% discount on stock purchased as you describe in your article.

- Any Dividends paid out during the month-long period are reinvested a the time of purchase at the same 15% discount.

I am currently investing 5% of my base salary in my ESPP… based on these details, how advantageous would it be for me to invest more?

Thanks!!

Dave

First, a reminder: I’m not a financial planner. Don’t make significant financial decisions based solely on my advice. There is no way I can possibly know enough about your situation to make an accurate recommendation.

If you download the spreadsheet I posted, you can shift the assumptions to monthly contributions. The end result will be similar – you get a very high IRR (internal rate of return), because you don’t have to put all the money up front, but make contributions every month. So that last check you write, one month before you cash out, has a very high rate of return since you get 15% for just 1 month of investment.

Personally, I always contributed the maximum to ESPP when I worked for a company that had it.

Hey Adam,

My ESPP is coming up to its 6 month maturity date. I’ve been investing 10% the whole 6 month period and have about $2,100 invested. How should I proceed when my renewal date comes up? Should I just sell the stock? What capital gains/tax implications are there for this money?

I’m young and I work at staples inc, I’ve been thinking about taking part in the ESPP. There’s a lot of good information here but there’s 1 thing I haven’t been able to find out, how do you sell the stock?

Does the program do it for you? Do I have to trade it myself? I assume there’s some kind of interface to make these decisions, like a website? Not asking about staples specifically (I realize the answer would be I have to ask them about it myself), but I’m wondering about your experience, or anyone else.

Hi, our stock went from $42 to 52. I never sign up for ESPP, is it a good time to enroll now or wait till the stock drops back to $42. I’m not sure if I sign up and if stock drops, will I get some shares back? We have open enrollment window till just July 31st, THanks

Hi Anela,

Most ESPP programs take the lowest stock price from either the beginning or ending of the period, so when the stock rises you get an extra benefit of purchasing at discount to the lowest price. Unfortunately, I can’t answer the question for you personally about whether you should enroll in your ESPP program or not.

Adam

Hi, you mentioned that you’ve always purchased ESPP from the companies you worked at. What’s your selling strategy like? Do you tend to sell them the first chance you get? Or does it depends on the stock trend – meaning you will continue to hold the ESPP if you believe the stock price will rise?

I recommend that you sell the stock right away. If you want to own more of your company’s stock, then just buy the amount that you want at the price that you want. There is no benefit to tying that decision to ESPP participation. Adam’s calculations assume that you sell the stock at the same price that it is acquired.

In the past, I tried holding the ESPP shares to get a tax benefit, but I think the benefit is small compared to the risk of a loss and the cost of tying up your money longer. (I realize that on a steady-state basis, any losses cancel out, but I am interested in edge conditions when I change employers.)

Hi Adam,

I have replicated your results in a spreadsheet, so your calculation is clearly correct. The problem is that the result is highly sensitive to the timing of the cash flows. I think that the IRR is overvaluing the apparent short-term gains, due to annualizing modest gains in very short time spans. Try changing the date of the payout, for example. If it is moved from 7/01 to 7/15, the IRR is 80.7%. If the timing of the payroll deductions is changed such that it is front-loaded[1] and, in the extreme, all $4250 is taken on 1/14, then the IRR falls to 42.3%. Sure, ESPP still looks great, but if you are evaluating investments for your company, are you going to be happy with a financial analysis that is that sensitive?

This is one of the flaws of IRR. NPV is a better choice. IRR seems to be used primarily because it is more intuitive than NPV. In this case, however, I believe NPV (use XNPV in Excel) gives the more intuitive answer.

Using your original example and a discount rate of 10%, the NPV is $627.25. That is less than the $750 cash return, which makes perfect sense, because you are loaning the company money from your paycheck which they return later in the form of stock! In the case of extreme front-loading, the NPV is $535.44. So, you gain $92 in present value by spreading the payroll deductions over time.

Now, let’s look at some realistic discount rates in 2014. (All use your original schedule of payroll deductions.)

1-year T-bill = 0.12%, NPV=$748.45

Savings account = 0.75%, NPV=$740.17

HELOC = 4.5%, NPV=$692.51

Credit Card = 17%, NPV=$551.24

Payday Loan = 200%, NPV=($326.16)

Of course, if you have to borrow money at 98.4%, then the NPV is $0. That’s the IRR equation.

This clearly shows that even borrowing from a credit card in order to make ends meet during your first ESPP period is a good deal! After that, use the ESPP savings from the prior period to supplement income from the next. In short, living paycheck to paycheck is no excuse for leaving this money on the table if your company offers it.

Jeff

[1] This is actually why I started researching ESPP today. I am maxing out my ESPP participation and the result is some degree of front-loading. They will take money out at the percent that I specify each pay period, and then stop when the annual IRS limit is reached.