Mittwoch, 5. August 2009

Behavioral Corporate Finance 1: The Objective in Decision Making

Aswath Damodaran about the objective in decision making:

Every business needs a central objective that drives decision making. In traditional corporate finance, that objective is to maximize the value of the firm. For publicly traded firms, this objective often is modified to maximizing stock prices. In effect, any decision that increases stock prices is viewed as a good decision and any decision that reduces stock prices is a bad one. Implicitly, we are assuming that investors are (for the most part) rational and that markets are efficient, that stock prices reflect the long term value of equity and that bond holders are fully protected from expropriation.

A central theme of behavioral finance is that markets are not efficient and investors often behave in irrational ways. Consequently, stock prices can not only deviate from long term equity value but managers can exploit investor irrationalities for their own purposes. Asking managers to maximize stock prices in this environment can lead to decisions that hurt the long term value of the firm and in some cases put the firm's survival at risk. Behavioral finance theorists therefore argue that decision making should not be tied to stock prices, though they do not seem to have reached a consensus on what should drive business choices instead.

Here is where I come down in this debate. I agree with behavioral finance theorists that managers should not tailor decisions to keep investors (or analysts) happy in the short term. Too many firms have followed this path to destruction, by buying back stock or borrowing money, just because that is the flavor of the moment. Managers should focus on increasing long term value, but I think it is a mistake to ignore the messages that they get from market reactions to their decisions. When stock prices go up or down on the announcement of an action, there is some aspect of that action that is pleasing or troubling to investors. All too often, markets turn out to be right and managers to be wrong in the long term. In fact, managers who are convinced that their decisions will increase firm value are often operating under some of the same behavioral quirks that affect investors - they are over confident and systematically over estimate their abilities.

I think that the objective in decision making in a publicly traded firm should be value maximization with a market feedback loop.

In effect, managers should make decisions that maximize firm value but should use the stock price reaction to both frame those decisions in ways that appeal to investors, and modify the decisions themselves. Here is a simple illustration of how this process will work. Let us assume that you, as managers of a publicly traded firm, believe that the firm are over levered and that issuing new equity and retiring debt is the action you need to take to maximize long term firm value. Your initial announcement is greeted badly by investors, with your stock price going down. At one level, this reflects the fear (some may say irrational) of any action that increases shares outstanding - the dilution bogeyman. At another, it reflects skepticism about managerial claims that the firm is over levered. Here is how you could modify your decision to meet investor concerns/ beliefs. Rather than issue shares, you may raise equity using warrants (which do not seem to evoke the same fear of dilution) and provide more information to investors about why you believe that you are over levered. I know that there is no guarantee that this will work but I think it is worth a try.

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