The Agency Costs of Overvalued Equity - Michael C. Jensen

Here are my notes. They are rough notes and may be a bit inaccurate or unclear.

Any time two or more people try to engage in cooperative activities, there is a cost because they never have the same preferences.

Stock options should be adjusted to dividends and cost of capital or their incentives are not aligned with shareholders.

If you as a manager find yourself in a situation where your stock is overvalued. It sets up pressures that cause people to destroy value. When an executive commits fraud to deliver market expectation, they know it's overvalued. 70bn peak but was worth 30bn for Enron. They had a choice of defending the 70bn or confess that it's really only worth 30bn. The board and the investors won't feel that it is value reseting, but rather value destruction and would fire the CEO and look for someone who could perform. No easy way to correct. Probably prevent from getting there. If you're there, you've probably lost your job.

Enron could have stopped the run-up, but they didn't see the downside of the run-up. "Charlie and I get just as uneasy when a company is selling for more than the intrinsic value than when it is trading at less." - Warren Buffet.

Overvaluation is managerial heroin. Feels good at the beginning, but turns out really bad at the end. The pressures of the market cause messing with the gray area of accounting. People raise money to buy companies and destroy more value. Funding of risky investment.

For every $1 in the purchase price, $2.31 is lost in the value of the firm for Nortel when investors realized that the acquisitions were not adding value. Companies destroy value with acquisitions. They con the market into believing that they can add value so it postpones the day of reckoning, but it eventually comes and comes bigger. Bad acquisitions were overwhelmingly with stock. Auctions with multiple irrational people increasing irrationality.

Throwing stock options in is like throwing gasoline on the fire. The solution is in the governance system. Can't solve all problems with incentive systems. You need honest and intelligent people who are monitoring. Unwinding constraints. Lockups after vesting.

Why did the shorts shut down shop at the beginning of the turn-around and didn't correct the problems.

95% of waste from stock options went to people lower than the top five officers. Some people think it is costless to issue options, but this isn't true.

DON'T LET YOUR STOCK GET OVERVALUED. If your stock is overvalued, YOU ARE GOING TO BE IN TROUBLE.

Solution for not having stock overvalued. Communicate your strategy. Don't forecast earnings in value. Publish audit-able metrics for strategy. Stop producing short term earnings forecasts. Would not even do rolling 12 month earnings forecast. Managers should not be in business of forecasting.

2 Comments

the problem is that the interests of shareholders and management are not really aligned. When over-valuation happens, management tends to see an opportunity to make a quick killing within a short period of time. This in turn drives away long-term investors (who know what is going to happen next and cannot afford to be involved with it) and attracts speculators who are out for a quick buck.

Overvaluation is not like heroin for management. Heroin has no long-term upside. Overvaluation has a clear rational upside for the management. It's the company that suffers as a result.

The steps described for remedying overvaluation are like using an eye-dropper to put out a fire.

Overvaluation is fundamentally a problem caused by lack of information, not misaligned preferences.

If management thinks their stock is overvalued, what this is saying is that "the management's estimate of the value of the firm is less than the investor's estimate of the value of the firm".

The solution is for management to give shareholders all the information they have. That way, shareholders will generally come to the similar conclusions as the management. That's the essence of Jensen's argument, and the reason that he proposes giving lots more information to shareholders.

The solution has nothing to do with how misaligned incentives are; even if the managers prefer to play golf all day and let the company run itself into the ground, the company will not be overvalued provided that shareholders have all the relevant information.

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