A (Company) Stock Answerby Stephen W. Philbrick
Suppose you are employed by a publicly held company, and your employer makes it possible for you to buy company stock. How much should you buy? If the company does not offer a discount, there is a simple rule of thumb. The rule is: DON'T. An individual desiring diversification should not have more than 3 percent to 5 percent exposure to a single stock. But employment itself constitutes exposure to a stock. A company in financial difficulty may well engage in layoffs at the same time their stock price is lagging. A substantial exposure to company stock could result in a double whammyweak stock performance at the same time that an employee incurs the financial impact of looking for a new job. It isn't immediately obvious how to translate the condition of employment into a percentage exposure to stock, but it seems likely that it is worth more than 3 percent to 5 percent. Thus, absent financial incentives, employees should avoid investing in their employers' stock.
Virtually all 401k plans have a variety of investment options, many of which include an option for company stock. In most cases, one should not allocate any portion to company stock. Why do companies offer this option? A company has a vested interest in stock ownership by employees. The main reason is that it helps align the interest of the employee with the interests of the company. If an important company decision arises that requires a vote of shareholders, such as a takeover proposal, it is expected that employees will vote in accord with the long-term best interests of the company. However, since an employee also faces an employment risk, it is not a financially prudent decision to buy stock in one's employer.
In my May column, I made this point, but I noted that there is an important exception. When company stock is offered at a discount, it may make sense to participate. This column will explore how much stock you can buy in your employer when there is a financial incentive to do so. (Participation in employer option plans also requires an analysis of the benefits of the plans compared to the costs of concentration, but the rule of thumb developed in this column does not apply to options.) Some companies offer stock at a discount to the market price. Typically, this is coupled with a required holding period, to ensure that the employee does not simply flip the stock. Some plans include a guaranteed floor, a guarantee that the value of the stock will not fall below the purchase price. When a company offers stock at a discount, this is equivalent to offering an automatic return on the stock that exceeds the return available in the market. When this occurs, one can justify purchase of company stock. The obvious question ishow much?
There is a formula. The derivation is beyond the scope of this column, although I will note that the formula does appear in a slightly different form in a syllabus reading (Bodie, Kane, and Marcus, page 215). I will note that the answer is dependent on several parameters, including:
- The expected return on risk-free securities
- The expected return on the equity market in total
- The standard deviation of the equity market returns
- The standard deviation of the return on the particular stock in question
- Beta of the stock (the covariance of the particular stock and the market divided by the variance of the market)
- The annual discount
The formula is moderately complicated. I'll provide a spreadsheet (.xls) on the Web Site, which will provide some motivation to find the answer as well as a formula to calculate the answer for individual companies. However, based upon looking at a few sample companies, I've formed a rough rule of thumb:
For large, stable companies, one can justify an allocation in an equity portfolio equal to the discount. That is, if the annual value of the discount is 10 percent, one could have as much as 10 percent exposure to employer stock. If you work for any company other than the dozen or so companies with very stable stock prices, your exposure should be no more than half the discount. That is, if your employer offers a 10 percent discount on company stock, you can only justify holding 5 percent of your total equity portfolio in this stock.
Some people will find these rules surprisingly low. For example, at Enron, many employees were allocating most of their retirement funds into Enron stock. This could only be reasonably justified if the company was offering a substantial discount.
Diversification is a powerful tool. It takes a substantial discount to overcome the disadvantages of concentration in a single stock.