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Agency Costs of Overvalued Equity


Michael C. Jensen


Harvard Business School; Social Science Electronic Publishing (SSEP), Inc.; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

March 2005

ECGI - Finance Working Paper No. 39/2004
Harvard Business School NOM Working Paper No. 04-26
Financial Management, Vol. 34, No. 1, Spring 2005

Abstract:     
I define and analyze the agency costs of overvalued equity. They explain the dramatic increase in corporate scandals and value destruction in the last five years; costs that have totaled hundreds of billions of dollars. When a firm's equity becomes substantially overvalued it sets in motion a set of organizational forces that are extremely difficult to manage - forces that almost inevitably lead to destruction of part or all of the core value of the firm. WorldCom, Enron, Nortel, and eToys are only a few examples of what can happen when these forces go unmanaged. Because we currently have no simple solutions to the agency costs of overvalued equity this is a promising area for future research.

The first step in managing these forces lies in understanding the incongruous proposition that managers should not let their stock price get too high. By too high I mean a level at which management will be unable to deliver the performance required to support the market's valuation. Once a firm's stock price becomes substantially overvalued managers who wish to eliminate it are faced with disappointing the capital markets. This value resetting (what I call the elimination of overvaluation) is not value destruction because the overvaluation would disappear anyway. The resulting stock price decline will generate substantial pain for shareholders, board members, managers and employees, and this makes it difficult for managers and boards to short circuit the forces leading to value destruction. And when boards and managers choose to defend the overvaluation they end up destroying part or all of the core value of the firm. WorldCom, Enron, Nortel, and eToys are only a few examples of what can happen if these forces go unmanaged. Control markets cannot solve the problem because you cannot buy up an overvalued firm, eliminate the overvaluation and make money. Equity-based compensation cannot solve the problem because it makes the problem worse, not better. While it is puzzling that short selling was unable to resolve the problem the evidence seems to be consistent with the Shleifer and Vishny (1997) arguments for the limits of arbitrage.

It appears the solution to these problems lies in the board of directors and the governance system. But that is a problem because there is substantial evidence that weak governance systems have failed widely. It also appears that boards and audit committees would be well served by communicating with and carefully evaluating the information that could be provided by short sellers of the firm's securities.

Number of Pages in PDF File: 18

Keywords: Overpriced Equity, Market Mistakes, Misvaluation, Faillure of Corporate Governance, Control, Incentives, optimism

JEL Classification: D21, D23, D84, G12, G14, G31, G34, J33, K22, M14

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Date posted: March 29, 2004 ; Last revised: May 6, 2009

Suggested Citation

Jensen, Michael C., Agency Costs of Overvalued Equity (March 2005). ECGI - Finance Working Paper No. 39/2004; Harvard Business School NOM Working Paper No. 04-26; Financial Management, Vol. 34, No. 1, Spring 2005. Available at SSRN: http://ssrn.com/abstract=480421

Contact Information

Michael C. Jensen (Contact Author)
Harvard Business School ( email )
Soldiers Field
Negotiations, Organizations & Markets
Boston, MA 02163
United States
617-510-3363 (Phone)
305-675-3166 (Fax)
HOME PAGE: http://drfd.hbs.edu/fit/public/facultyInfo.do?facInfo=ovr&facId=6484
Social Science Electronic Publishing (SSEP), Inc. ( email )
7858 Sanderling Road
Sarasota, FL 34242
United States
617-510-3363 (Phone)
305 675-3166 (Fax)
HOME PAGE: http://ssrn.com/author=9

National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
European Corporate Governance Institute (ECGI) ( email )
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
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