Agency Costs of Overvalued Equity
ECGI European Corporate Governance Institute Finance Working Paper No. 39/2004 Negotiation, Organization and Markets Harvard University Working Paper No. 04-26
Agency Costs of Overvalued Equity
Michael C. Jensen
Harvard Business School; The Monitor Company; Social Science Electronic Publishing (SSEP), In.
This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at: http://ssrn.com/abstract=480421
MICHAEL C. JENSEN
April 2004
Agency Costs of Overvalued Equity
Michael C. Jensen mjensen@hbs.edu Jesse Isidor Straus Professor, Emeritus, at Harvard Business School; Managing Director of the Organizational Strategy Practice at Monitor Group, Cambridge, Massachusetts Abstract The recent dramatic increase in corporate scandals and value destruction is due to what I call the agency costs of overvalued equity. I believe these costs have amounted to hundreds of billions of dollars in recent years. 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. 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. The prospect of this value resetting pain makes it difficult for managers and boards to
Agency Costs of Overvalued Equity
Michael C. Jensen
Harvard Business School; The Monitor Company; Social Science Electronic Publishing (SSEP), In.
This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection at: http://ssrn.com/abstract=480421
MICHAEL C. JENSEN
April 2004
Agency Costs of Overvalued Equity
Michael C. Jensen mjensen@hbs.edu Jesse Isidor Straus Professor, Emeritus, at Harvard Business School; Managing Director of the Organizational Strategy Practice at Monitor Group, Cambridge, Massachusetts Abstract The recent dramatic increase in corporate scandals and value destruction is due to what I call the agency costs of overvalued equity. I believe these costs have amounted to hundreds of billions of dollars in recent years. 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. 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. The prospect of this value resetting pain makes it difficult for managers and boards to
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