Jensen (2005) Overvalued Equity

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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 short circuit the forces leading to destruction of part or all of the core value of the firm. And in many cases managers choosing to defend the overvaluation instead 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. It is puzzling that short selling was unable to resolve the problem. It appears the solution to these problems lies in the board of directors and the governance system, and there is substantial evidence that weak governance systems have failed. Keywords: Overpriced Equity, Market Mistakes, Misvaluation, Failure of Corporate Governance, Control, Incentives This paper is drawn from “The Agency Cost of Overvalued Equity and the Current State of Corporate Finance” (Keynote Lecture, European Financial Management Association), London, June 2002. This paper is available at no charge from the Social Science Research Network eLibrary at: http://papers.ssrn.com/Abstract=480421 Copyright © 2004 Michael C. Jensen. All rights reserved.

Copyright © 2004 Michael C. Jensen. All rights reserved.

April 2004

Agency Costs of Overvalued Equity1
Michael C. Jensen
mjensen@hbs.edu Jesse Isidor Straus Professor, Emeritus, Harvard Business School; Managing Director Organizational Strategy Practice, Monitor Group, Cambridge, Massachusetts.

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...
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