Michael C. Jensen*
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.
In the past few years, we have seen many fine companies end up in ruins and watched record numbers of senior executives go to jail. And we will surely hear of more investigations, more prison terms, and more damaged reputations. Shareholders and society have borne value destruction in the hundreds of billions of dollars.
What went wrong? Were managers overtaken by a fit of greed? Did they wake up one morning and decide to be crooks? No. Although there were some crooks in the system, the root cause of the problem was not the people but the system in which they were operating—a system in which equity became so dangerously overvalued that many CEOs and CFOs found themselves caught in a vicious bind where excessively high stock valuations released a set of damaging organizational forces that led to massive destruction of corporate and social value. And the problem was made far worse than it had to be because few managers or boards had any idea of the destructive forces involved.
I. What is Overvalued Equity?
Equity is overvalued when a firm’s stock price is higher than its underlying value. And the problems I shall be discussing today arise not when there are small overvaluations, but when there is substantial overvaluation, say by 100 or 1,000%. By definition, an overvalued equity means the company will not be able to deliver—except by pure luck—the performance to justify its value. If it could it would obviously not be overvalued.
To my knowledge, with the exception of Warren Buffett (who hints at these forces in his 1988 letter to Berkshire shareholders)1 no leaders in the business and financial community have Copyright © 2005 Michael C. Jensen, All Rights Reserved.
“We do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value…Charlie Munger and I are bothered as much by significant overvaluation as significant undervaluation.” Warren Buffett, Berkshire Hathaway Annual Report, 1988.
This paper is drawn from my Keynote Lecture to the October 2004 Financial Management Association New Orleans Meetings.The first version of these ideas was presented at the European Financial Management Association, London, June 2002, see Jensen (2004). I am indebted to Joe Fuller, Kevin Murphy, Harry and Linda DeAngelo, Jeff Skelton and Eric Wruck for conversations on these issues and to Editors Lemma Senbet, Jim Seward, and Alex Triantis, and anonymous referees for suggestions *
Michael C. Jensen is the Jesse Isidor Straus Professor, Emeritus, Harvard Business School and is the Managing Director of the Organizational Strategy Practice, Monitor Group in Cambridge, MA. Financial Management • Spring 2005 • pages 5 - 19
Financial Management • Spring 2005
recognized the dangers of overvalued equity. Nor have they publicly acknowledged their frequent contributions to creating this overvaluation.
Almost 30 years ago when Bill Meckling and I wrote our original paper on Agency Theory (Jensen and Meckling, 1976), we defined agency costs as the costs associated with cooperative effort by human beings. We focused on the agency costs arising when one entity, the principal, hires another, the...