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
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