Academic journal article Financial Management

Agency Costs of Overvalued Equity

Academic journal article Financial Management

Agency Costs of Overvalued Equity

Article excerpt

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.

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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 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 agent, to act for him or her. While the issues are general, we developed the theory in the context of the conflicts of interest between corporate managers and outside equity and debt holders. We defined agency costs as the sum of the contracting, monitoring and bonding costs undertaken to reduce the costs due to conflicts of interest plus the "residual loss" that occurs because it is generally impossible to perfectly identify the agents' interests with that of the principal. In that article and others since then, we (and others) viewed markets as potent forces to help control agency costs. What I am going to describe today is how securities markets can sometimes create and exacerbate conflicts of interest between managers and owners rather than resolve them. Thus, this paper can be understood as expanding the range of costly conflicts of interest that the Agency Model can handle, in particular market and managerial optimism (even delusion) and the forces that allow or even encourage markets to become enablers of value destroying managerial behavior. I hasten to add that the problems I am addressing here are difficult ones and I do not have solutions that I consider satisfactory at this time. …

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