The Agency Cost of Overvalued Equity and the Current State of Corporate Finance

Abstract:     
Keynote Address to the European Financial Management Association, London, June 2002
This paper received the European Financial Management Readers' Choice Best Paper Award for 2004

My intention today is to provide a way to understand some of what's currently happening in the world of finance and corporate governance at this time (June 2002). Few if any of us have discussed with our students the consequences of a company's stockprice becoming overvalued. Indeed I know of nowhere in the finance literature where the problems associated with overvaluation are discussed. We talked for a long time in the 1980s about the effects of under-valuation, and I will have a little to say about that below. But as things have progressed over the last half-dozen years overvaluation has come increasingly to occupy my thoughts.

Indeed, understanding the incentive and organisational effects of stock overvaluation will help us understand much about the current malaise in corporate finance and corporate governance that surrounds the events at Enron, WorldCom, Xerox, and many other companies. I will review this situation briefly, and then move on to consider the agency costs of undervalued and overvalued equity. For the most part I'm going to concentrate on the latter, and examine the necessity for managers to manage stockprices down in situations where they become substantially overvalued, and the requirement for us to have new language to enable managers and boards to deal with these issues. I will conclude by considering how we solve this, where we go from here, and what's likely to happen?

Number of Pages in PDF File: 19

Keywords: Overvalued equity, Agency costs, budgeting, managing earnings, integrity, lying, scandals

JEL Classification: G12, G14, G34, J33, K22, M14, M52

Accepted Paper Series