Jensen

Good Essays
Agency Costs of Overvalued Equity
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



References: Aghion, P. and J.C. Stein, 2004, “Growth vs. Margins: Destabilizing Consequences of Giving the Stock Market What It Wants,” Harvard Business School Working Paper Baker, M., J.C. Stein, and J. Wurgler, 2003, “When Does the Market Matter? Stock Prices and the Investment of Equity-Dependent Firms,” Quarterly Journal of Economics 118, 203-218 Baker, M. and J. Wurgler, 2002, “Market Timing and Capital Structure,” Journal of Finance 57, 1-32. Belson, K., 2005, “WorldCom’s Audacious Failure and Its Toll on an Industry,” New York Times, Jan. 18. Cramer, J.J., 2002, Confessions of a Street Addict, New York, NY, Simon & Schuster. Efendi, J., A. Srivastava, and E.P. Swanson, 2004, “Why Do Corporate Managers Misstate Financial Statements? The Role of Option Compensation, Corporate Governance, and Other Factors,” Texas Endlich, L., 2004, Optical Illusions: Lucent and the Crash of Telecom, New York, NY, Simon & Schuster. Fama, E.F. and K.R. French, 1992, “The Cross Section of Expected Stock Returns,” Journal of Finance 47, 427-465. Fuller, J. and M.C. Jensen, 2002, “Just Say No To Wall Street: Putting A Stop To the Earnings Game,” Journal of Applied Corporate Finance 14, 41-46 Glater, J.D., 2005, “Restatements, and Lawsuits, are on the Rise,” New York Times, January 20. Graham, J.R., C.R. Harvey, and S. Rajgopal, 2005, “The Economic Implications of Corporate Financial Reporting,” Journal of Accounting and Economics (Forthcoming) Harrison, J.M. and D.M. Kreps, 1978, “Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations,” Quarterly Journal of Economics 92, 323-336. Heaton, J.B., 2002, “Managerial Optimism and Corporate Finance,” Financial Management: 31, 33-45. Holmstrom, B.R. and S.N. Kaplan, 2003, “The State of US Corporate Governance: What’s Right and What’s Wrong?” ECGI - Finance Working Paper Jensen, M.C., 1986a, “Agency Costs of Free Cash Flow: Corporate Finance and Takeovers,” American Economic Review 76, 323-329 Jensen, M.C., 1986b, “The Takeover Controversy: Analysis and Evidence,” Midland Corporate Finance Journal 4 Jensen, M.C., 1988, “Takeovers: Their Causes and Consequences,” Journal of Economic Perspectives 2, 21-48. Jensen, M.C., 1989, “Active Investors, LBOs, and the Privatization of Bankruptcy,” Journal of Applied Corporate Finance 2, 35-44 Jensen, M.C., 1993, “The Modern Industrial Revolution, Exit and the Failure of Internal Control Systems,” Journal of Finance 6, 831-880 Jensen, M.C., 2001, “Corporate Budgeting Is Broken: Let’s Fix It,” Harvard Business Review 79, 94-101. Jensen, M.C., 2003, “Paying People to Lie: The Truth About the Budgeting Process,” European Financial Management 9, 379-406 Jensen, M.C., 2004, “The Agency Cost of Overvalued Equity and the Current State of Corporate Finance (2002 Keynote Lecture: European Financial Management Association, London),” European Financial Jensen, M.C., K.J. Murphy, and E.G. Wruck, 2004, “Remuneration: Where We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them,” Harvard NOM Working Paper Johansen, A. and D. Sornette, 2000, “The Nasdaq Crash of April 2000: Yet Another Example of LogPeriodicity in a Speculative Bubble Ending in a Crash,” European Physical Journal B 17, 319-328. Jones, C.M. and O.A. Lamont, 2002, “Short Sale Constraints and Stock Returns,” Journal of Financial Economics 66, 207-239 Kindleberger, C., 1978, Manias, Panics, and Crashes, New York, NY, Basic Books. Lamont, O.A., 2004, “Go Down Fighting: Short Seller vs. Firms,” Yale ICF Working Paper, No. 04-20. Lamont, O.A. and J.C. Stein, 2004, “Aggregate Short Interest and Market Valuations,” American Economic Review 94, 29-32 Lamont, O.A. and R.H. Thaler, 2003, “Can the Market Add and Subtract? Mispricing in Tech Stock CarveOuts,” Journal of Political Economy 111, 227-268. Available from the SSRN eLibrary at: http://ssrn.com/ abstract=249981. Martin, D., 2005, Tough Calls: AT&T and the Hard Lessons Learned from the Telecom Wars, New York, NY, Amacon. McLean, B. and P. Elkind, 2003, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, New York, NY, Penguin Group. Moeller, S., F.P. Schlingemann, and R.M. Stulz, 2005, “Wealth Destruction on A Massive Scale? A Study of Acquiring-Firm Returns in the Recent Merger Wave,” Journal of Finance (Forthcoming) Myers, S.C. and N.S. Majluf, 1984, “Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have,” Journal of Financial Economics 13, 187-221. Pastore, L. and P. Veronesi, 2004, “Was There a Nasdaq Bubble in the Late 1990s?” CRSP No. 557 Working Paper Polk, C. and P. Sapienza, 2004, “The Real Effects of Investor Sentiment,” Northwestern University Working Paper Shleifer, A. and R.W. Vishny, 1997, “The Limits of Arbitrage,” Journal of Finance 52, 35-55. Available from the SSRN eLibrary at: http://papers.ssrn.com/abstract=225230. Shleifer, A. and R.W. Vishny, 2003, “Stock Market Driven Acquisitions,” Journal of Financial Economics, 70, 295-311 Skinner, D.J. and R.G. Sloan, 2002, “Earnings Surprises, Growth Expectations, and Stock Returns or Don’t Let an Earnings Torpedo Sink Your Portfolio,” Review of Accounting Studies 7, 289-312. Sokolove, M., 2002, “How to Lose $850 Million—And Not Really Care,” New York Times Magazine, June 9. Swartz, M. and S. Watkins, 2003, Power Failure: The Inside Story of the Collapse of Enron, New York, NY, Doubleday.

You May Also Find These Documents Helpful

  • Satisfactory Essays

    BUSI 530 DB2 2 reply

    • 192 Words
    • 1 Page

    Brealey, R. A., Myers, S. C., & Marcus, A. J. (2012). Fundamentals of Corporate Finance. New York: McGraw-HIll/Irwin.…

    • 192 Words
    • 1 Page
    Satisfactory Essays
  • Satisfactory Essays

    Giant Pool of Money

    • 299 Words
    • 2 Pages

    Conflicts of interest, shifts in corporate culture, heightened competitive pressures, and lack of regulatory oversight created a perfect storm that enveloped the entire economy.…

    • 299 Words
    • 2 Pages
    Satisfactory Essays
  • Better Essays

    Companies that have been in business for many years before their fortunes decline are the victims of a relatively small number of problems. The first of these is bad management. This has happened at Boeing (NYSE: BA) and Dell (NASDAQ: DELL). Executives often make mistakes in executing their plans. The Boeing's 787, for example, has been delayed several times. Dell has had legal problems and, according to some…

    • 3844 Words
    • 10 Pages
    Better Essays
  • Good Essays

    Case 30

    • 701 Words
    • 3 Pages

    Was the Whirlpool plant closing just another “business decision,” or did it carry with it social and ethical responsibilities and implications? Explain…

    • 701 Words
    • 3 Pages
    Good Essays
  • Good Essays

    Q.3. Is there anything else that can be done to curtail this sort of egregious business behaviour (scandals) other than legislation?…

    • 659 Words
    • 3 Pages
    Good Essays
  • Satisfactory Essays

    First, the company was not well organized. The company does not have complete appraisal system and clear job descriptions. Then, staffs have poor performance at working. They took little responsibility, and had some immoral behaviors. Finally, some managers were not qualified to the job.…

    • 469 Words
    • 2 Pages
    Satisfactory Essays
  • Good Essays

    As mentioned previously, stocks are an important part in a company’s worth. The market value of stocks change as investors buys and sells their shares. Many times investors think that the market value of a stock is incorrect and the market value can be overvalued or undervalued depending on their analysis of its worth. Although markets and investors value stocks, they value them differently. Investors influence the price of a stock based on the investor’s analysis of the company’s future earnings. Investors pay more for companies than its market value to make sure all shares are owned. Investors value stock very much because they can easily manipulate the price and value of a stock; this gives them a large amount of power over the market. For investors the buying and selling of stocks becomes a game to see how much they can buy or sell while also manipulating the market.…

    • 452 Words
    • 2 Pages
    Good Essays
  • Better Essays

    The internet bubble that burst in March, 2000 is followed with much larger and more devastating collapse: Telecom. WorldCom’s financial statements were far worse than expectation that would result in stock price fall, downgrading company and most importantly—losing capital to acquire companies. Then CEO and CFO were planning to change the financial statements with mid-level accountants. They thought if the financial statements were better in next quarter, they could cover the change. But things didn’t go according to plan. They had to change the number until the whistle blew.…

    • 1104 Words
    • 5 Pages
    Better Essays
  • Good Essays

    Inside the Meltdown

    • 490 Words
    • 2 Pages

    The stock of a global investment company, Bear Stearns, began to drop drastically on March 10th, 2008. A share of Bear Stearns was as high as $171 and by the afternoon dropped to $57. Former CEO of the company, Ace Greenberg, tells CNBC that all of these rumors are “ridiculous.” As time goes on, Bear Stearns’ cash reserves were disappearing and people invested in the company were immediately withdrawing. Bear Stearns was basically racing to find a company to buy them out or they would go under. Current CEO of Bear Stearns, Alan Schwartz, got ahold of JP Morgan’s CEO, Jamie Dimon, to buy out Bear. A ton of government officials come to Bear to look over their records and it is not a pretty sight. Bear was deep in toxic assets. The Federal Reserve was prohibited from lending any money to Bear so they used JP Morgan to bail out Bear Stearns. Unfortunately the company could not be saved and Bear Stearns was gone after being sold to JP Morgan at $2 per share.…

    • 490 Words
    • 2 Pages
    Good Essays
  • Good Essays

     The company was being mismanaged or not managed correctly. It seemed as thought the company lived by a rule of, “As long you can get away with it, then your action were okay.…

    • 858 Words
    • 4 Pages
    Good Essays
  • Satisfactory Essays

    Money took over and everyone who had a part in this theory started to maximise the value of their concern. One example is Jack Welch who maximised shareholder value from $14b to $484b.…

    • 266 Words
    • 2 Pages
    Satisfactory Essays
  • Satisfactory Essays

    Mgt/521 Week 3

    • 653 Words
    • 3 Pages

    Like all companies, there is an ebb and flow of revenue and company success. For a…

    • 653 Words
    • 3 Pages
    Satisfactory Essays
  • Satisfactory Essays

    Enterprise Rent-a-Car

    • 684 Words
    • 3 Pages

    People did not know much about Enterprise and hence this was another biggest drawback. If these conditions would prevail, Enterprise could start loosing their market share and enjoyment of handsome revenue as consumers…

    • 684 Words
    • 3 Pages
    Satisfactory Essays
  • Powerful Essays

    Busm 301 Ch1

    • 2183 Words
    • 9 Pages

    A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely. A stock’s current price is its market price—the value based on perceived but…

    • 2183 Words
    • 9 Pages
    Powerful Essays
  • Powerful Essays

    Case Study on Sears

    • 9017 Words
    • 37 Pages

    The great advantage of publicly held companies is that they bring together capital and managerial expertise, to the benefit of both groups. An investor need not know anything about making or marketing chairs in order to invest in a chair factory. A gifted producer or seller of chairs need not have capital in order to start a business. When it runs well, both profit, and the capitalist system achieves its goals. Our system of capitalism has been less successful when the company does not run well. As some of America's most visible, powerful, and successful companies began to slide, they demonstrated an all-but fatal weakness in the ability of our system to react in time to prevent disaster. Managers and directors at companies like IBM, General Motors, and Sears took their success--and their customers--for granted. They took their investors for granted, too, until it was almost too late.…

    • 9017 Words
    • 37 Pages
    Powerful Essays

Related Topics