aswath damodaran - new york universitypeople.stern.nyu.edu/adamodar/pdfiles/ovhds/ch2.pdf · aswath...
TRANSCRIPT
Asw
ath Dam
odaran2
The O
bjective in Corporate F
inance
“If you don’t know w
here you are going, it does notm
atter how you get there”
Asw
ath Dam
odaran
Stern School of Business
Asw
ath Dam
odaran3
First P
rinciples
Invest in projects that yield a return greater than the minim
umacceptable hurdle rate.•
The hurdle rate should be higher for riskier projects and reflect the
financing mix used - ow
ners’ funds (equity) or borrowed m
oney (debt)•
Returns on projects should be m
easured based on cash flows generated
and the timing of these cash flow
s; they should also consider both positiveand negative side effects of these projects.
Choose a financing m
ix that minim
izes the hurdle rate and matches the
assets being financed.If there are not enough investm
ents that earn the hurdle rate, return thecash to the ow
ners of the firm (if public, these w
ould be stockholders).•
The form
of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.
Objective: M
aximize the V
alue of the Firm
Asw
ath Dam
odaran4
The C
lassical View
point
Van H
orne: "In this book, we assum
e that the objective of the firm is
to maxim
ize its value to its stockholders"
Brealey &
Myers: "Success is usually judged by value: Shareholders
are made better off by any decision w
hich increases the value of theirstake in the firm
... The secret of success in financial m
anagement is to
increase value."
Copeland &
Weston
: The m
ost important them
e is that the objectiveof the firm
is to maxim
ize the wealth of its stockholders."
Brigham
and Gapenski: T
hroughout this book we operate on the
assumption that the m
anagement's prim
ary goal is stockholder wealth
maxim
ization which translates into m
aximizing the price of the
comm
on stock.
Asw
ath Dam
odaran5
The O
bjective in Decision M
aking
In traditional corporate finance, the objective in decision making is to
maxim
ize the value of the firm.
A narrow
er objective is to maxim
ize stockholder wealth. W
hen thestock is traded and m
arkets are viewed to be efficient, the objective is
to maxim
ize the stock price.
All other goals of the firm
are intermediate ones leading to firm
valuem
aximization, or operate as constraints on firm
value maxim
ization.
Asw
ath Dam
odaran6
The C
riticism of F
irm V
alue Maxim
ization
Maxim
izing stock price is not incompatible w
ith meeting em
ployeeneeds/objectives. In particular:•
- Em
ployees are often stockholders in many firm
s
•- Firm
s that maxim
ize stock price generally are firms that have treated
employees w
ell.
Maxim
izing stock price does not mean that custom
ers are not criticalto success. In m
ost businesses, keeping customers happy is the route to
stock price maxim
ization.
Maxim
izing stock price does not imply that a com
pany has to be asocial outlaw
.
Asw
ath Dam
odaran7
Why traditional corporate financial theory
focuses on maxim
izing stockholder wealth.
Stock price is easily observable and constantly updated (unlike otherm
easures of performance, w
hich may not be as easily observable, and
certainly not updated as frequently).
If investors are rational (are they?), stock prices reflect the wisdom
ofdecisions, short term
and long term, instantaneously.
The objective of stock price perform
ance provides some very elegant
theory on:•
how to pick projects
•how
to finance them
•how
much to pay in dividends
Asw
ath Dam
odaran8
The C
lassical Objective F
unction
STO
CK
HO
LD
ER
S
Maxim
izestockholderw
ealth
Hire &
firem
anagers- B
oard- A
nnual Meeting
BO
ND
HO
LD
ER
SL
end Money
ProtectbondholderInterestsFIN
AN
CIA
L M
AR
KE
TS
SOC
IET
YM
anagers
Reveal
information
honestly andon tim
e
Markets are
efficient andassess effect onvalue
No Social C
osts
Costs can be
traced to firm
Asw
ath Dam
odaran9
What can go w
rong?
STO
CK
HO
LD
ER
S
Managers put
their interestsabove stockholders
Have little control
over managers
BO
ND
HO
LD
ER
SL
end Money
Bondholders can
get ripped off
FINA
NC
IAL
MA
RK
ET
S
SOC
IET
YM
anagers
Delay bad
news or
provide m
isleadinginform
ation
Markets m
akem
istakes andcan over react
Significant Social Costs
Some costs cannot be
traced to firm
Asw
ath Dam
odaran10
I. Stockholder Interests vs. M
anagement
Interests
Theory: T
he stockholders have significant control over managem
ent.T
he mechanism
s for disciplining managem
ent are the annual meeting
and the board of directors.
Practice: N
either mechanism
is as effective in discipliningm
anagement as theory posits.
Asw
ath Dam
odaran11
The A
nnual Meeting as a disciplinary venue
The pow
er of stockholders to act at annual meetings is diluted by three
factors•
Most sm
all stockholders do not go to meetings because the cost of going
to the meeting exceeds the value of their holdings.
•Incum
bent managem
ent starts off with a clear advantage w
hen it comes to
the exercising of proxies . Proxies that are not voted becomes votes for
incumbent m
anagement.
•For large stockholders, the path of least resistance, w
hen confronted bym
anagers that they do not like, is to vote with their feet.
Asw
ath Dam
odaran12
Board of D
irectors as a disciplinary mechanism
The A
verage Director: U
nderworked and O
verpaid
0 20 40 60 80
100
120
140
19851988
19921996
2000
Year
Hours worked per year
0 5000
10000
15000
20000
25000
30000
35000
40000
45000
50000
Annual Pay
Hours w
orked per yearA
nnual Pay
Asw
ath Dam
odaran13
The C
EO
hand-picks most directors..
The 1992 survey by K
orn/Ferry revealed that 74% of com
panies reliedon recom
mendations from
the CE
O to com
e up with new
directors;O
nly 16% used an outside search firm
.
Directors often hold only token stakes in their com
panies. The
Korn/Ferry survey found that 5%
of all directors in 1992 owned less
than five shares in their firms.
Many directors are them
selves CE
Os of other firm
s.
Asw
ath Dam
odaran14
Directors lack the expertise to ask the
necessary tough questions..
The C
EO
sets the agenda, chairs the meeting and controls the
information.
The search for consensus overw
helms any attem
pts at confrontation.
Asw
ath Dam
odaran15
The B
est Boards in 1997...
Asw
ath Dam
odaran16
And the W
orst Boards in 1997..
Asw
ath Dam
odaran17
Who’s on B
oard? The D
isney Experience -
1997
Asw
ath Dam
odaran18
A C
ontrast: Disney vs. C
ampbell S
oup in 1997
BE
ST P
RA
CT
ICE
S C
AM
PB
EL
L SO
UP
D
ISNE
Y
Majority of outside directors
Only one insider
7 of 17 mem
bers
among 15 directors
are insiders
Bans insiders on nom
inating Yes
No: C
EO
is
comm
ittee chairm
an of panel
Bans form
er execs from board
Yes
No
Mandatory retirem
ent age 70, w
ith none N
one
over 64
Outside directors m
eet w/o C
EO
Annually
Never
Appointm
ent of 'lead director'' Yes
No
Governance com
mittee
Yes
No
Self-evaluation of effectiveness Every tw
o years N
one
Director pensions
None
Yes
Share-ownership requirem
ent 3,000 shares
None
Asw
ath Dam
odaran19
Application T
est: Who’s on board?
Look at the board of directors for your firm
. Analyze
•H
ow m
any of the directors are inside directors (Em
ployees of the firm,
ex-managers)?
•Is there any inform
ation on how independent the directors in the firm
arefrom
the managers?
Asw
ath Dam
odaran20
Disney’s B
oard in 2002
Reveta F. Bowers:Head of School for the Center for Early Education
John E. Bryson:Chief Executive Officer of Edison International
Roy E. Disney: Nephew of the late Walt Disney
Michael D. Eisner: Chief Executive Officer of the Company
Judith L. Estrin:President and Chief Executive Officer of Packet Design
Stanley P. Gold: CEO of Shamrock Holdings, Inc., an investment firm
Robert A. Iger: President and Chief Operating Officer of the Company
Monica C. Lozano: President and Chief Operating Officer of La Opinion
George J. Mitchell:United States Senator from 1980 to 1995
Thomas S. Murphy: Chairman of the Board and CEO of Capital Cities/ABC
Leo J. O'Donovan, S.J:Professor of Theology at Georgetown University
Sidney Poitier: Actor, director and writer
Robert A.M. Stern:Architect, teacher and writer
Andrea L. Van de Kamp:Chairman of Sotheby's West Coast
Raymond L. Watson:Vice Chairman of the Board of The Irvine Company
Gary L. Wilson:Chairman of the Board of Northwest Airlines Corporation
Asw
ath Dam
odaran21
So w
hat next? When the cat is idle, the m
icew
ill play ....
When m
anagers do not fear stockholders, they will often put their
interests over stockholder interests•
Greenm
ail: The (m
anagers of ) target of a hostile takeover buy out thepotential acquirer's existing stake, at a price m
uch greater than the pricepaid by the raider, in return for the signing of a 'standstill' agreem
ent.
•G
olden Parachutes: Provisions in em
ployment contracts, that allow
s forthe paym
ent of a lump-sum
or cash flows over a period, if m
anagerscovered by these contracts lose their jobs in a takeover.
•P
oison Pills: A
security, the rights or cashflows on w
hich are triggeredby an outside event, generally a hostile takeover, is called a poison pill.
•Shark R
epellents: Anti-takeover am
endments are also aim
ed atdissuading hostile takeovers, but differ on one very im
portant count. They
require the assent of stockholders to be instituted.
•O
verpaying on takeovers
No stockholder approval needed….. Stockholder Approval needed
Asw
ath Dam
odaran22
Overpaying on takeovers
The quickest and perhaps the m
ost decisive way to im
poverishstockholders is to overpay on a takeover.
The stockholders in acquiring firm
s do not seem to share the
enthusiasm of the m
anagers in these firms. Stock prices of bidding
firms decline on the takeover announcem
ents a significant proportionof the tim
e.
Many m
ergers do not work, as evidenced by a num
ber of measures.
•T
he profitability of merged firm
s relative to their peer groups, does notincrease significantly after m
ergers.
•A
n even more dam
ning indictment is that a large num
ber of mergers are
reversed within a few
years, which is a clear adm
ission that theacquisitions did not w
ork.
Asw
ath Dam
odaran23
A C
ase Study: K
odak - Sterling D
rugs
Eastm
an Kodak’s G
reat Victory
Asw
ath Dam
odaran24
Earnings and R
evenues at Sterling D
rugs
Sterling Drug under E
astman K
odak: Where is the synergy?
0500
1,000
1,500
2,000
2,500
3,0003,500
4,000
4,500
5,000
19881989
19901991
1992
Revenue
Operating E
arnings
Asw
ath Dam
odaran25
Kodak S
ays Drug U
nit Is Not for S
ale(N
YT
imes, 8/93)
An article in the N
Y T
imes in A
ugust of 1993 suggested that Kodak w
as eagerto shed its drug unit.
•In response, E
astman K
odak officials say they have no plans to sell Kodak’s
Sterling Winthrop drug unit.
•L
ouis Mattis, C
hairman of Sterling W
inthrop, dismissed the rum
ors as “massive
speculation, which flies in the face of the stated intent of K
odak that it iscom
mitted to be in the health business.”
A few
months later…
Taking a stride out of the drug business, E
astman K
odaksaid that the Sanofi G
roup, a French pharmaceutical com
pany, agreed to buythe prescription drug business of Sterling W
inthrop for $1.68 billion.•
Shares of Eastm
an Kodak rose 75 cents yesterday, closing at $47.50 on the N
ewY
ork Stock Exchange.
•Sam
uel D. Isaly an analyst , said the announcem
ent was “very good for Sanofi and
very good for Kodak.”
• “W
hen the divestitures are complete, K
odak will be entirely focused on im
aging,”said G
eorge M. C
. Fisher, the company's chief executive.
•T
he rest of the Sterling Winthrop w
as sold to Smithkline for $2.9 billion.
Asw
ath Dam
odaran26
Application T
est: Who ow
ns/runs your firm?
Look at: B
loomberg printout H
DS for your firm
Looking at the top 15 stockholders in your firm
, consider thefollow
ing:•
How
many of the top 15 investors are institutional investors?
•H
ow m
any of the top 15 investors are individual investors?
•A
re managers significant stockholders in the firm
?
Asw
ath Dam
odaran27
Disney’s top stockholders in 2002
Asw
ath Dam
odaran28
II. Stockholders' objectives vs. B
ondholders'objectives
In theory: there is no conflict of interests between stockholders and
bondholders.
In practice: Stockholders may m
aximize their w
ealth at the expense ofbondholders.•
Increasing dividends significantly: When firm
s pay cash out as dividends,lenders to the firm
are hurt and stockholders may be helped. T
his isbecause the firm
becomes riskier w
ithout the cash.
•T
aking riskier projects than those agreed to at the outset: Lenders base
interest rates on their perceptions of how risky a firm
’s investments are. If
stockholders then take on riskier investments, lenders w
ill be hurt.
•B
orrowing m
ore on the same assets : If lenders do not protect them
selves,a firm
can borrow m
ore money and m
ake all existing lenders worse off.
Asw
ath Dam
odaran29
Unprotected Lenders?
Asw
ath Dam
odaran30
III. Firm
s and Financial M
arkets
In theory: Financial markets are efficient. M
anagers conveyinform
ation honestly and truthfully to financial markets, and financial
markets m
ake reasoned judgments of 'true value'. A
s a consequence-•
A com
pany that invests in good long term projects w
ill be rewarded.
•Short term
accounting gimm
icks will not lead to increases in m
arketvalue.
•Stock price perform
ance is a good measure of m
anagement perform
ance.
In practice: There are som
e holes in the 'Efficient M
arkets'assum
ption.
Asw
ath Dam
odaran31
Managers control the release of inform
ation tothe general public
There is evidence that•
they suppress information, generally negative inform
ation
• they delay the releasing of bad new
s–
bad earnings reports
–other new
s
•they som
etimes reveal fraudulent inform
ation
Asw
ath Dam
odaran32
Evidence that m
anagers delay bad news..
DO
MA
NA
GE
RS
DE
LAY
BA
D N
EW
S?: E
PS
and DP
S C
hanges- byW
eekday
-6.0
0%
-4.0
0%
-2.0
0%
0.0
0%
2.0
0%
4.0
0%
6.0
0%
8.0
0%
Mo
nd
ay
Tu
es
da
yW
ed
ne
sd
ay
Th
urs
da
yF
rida
y
% C
hg
(EP
S)
% C
hg
(DP
S)
Asw
ath Dam
odaran33
Even w
hen information is revealed to financial
markets, the m
arket value that is set bydem
and and supply may contain errors.
Prices are much m
ore volatile than justified by the underlyingfundam
entals•
Eg. D
id the true value of equities really decline by 20% on O
ctober 19,1987?
financial markets overreact to new
s, both good and bad
financial markets are short-sighted, and do not consider the long-term
implications of actions taken by the firm
•E
g. the focus on next quarter's earnings
financial markets are m
anipulated by insiders; Prices do not have anyrelationship to value.
Asw
ath Dam
odaran34
Are M
arkets Short term
?
Focusing on market prices w
ill lead companies tow
ards short termdecisions at the expense of long term
value.
I agree with the statem
ent
I do not agree with this statem
ent
Asw
ath Dam
odaran35
Are M
arkets Short S
ighted? Som
e evidencethat they are not..
There are hundreds of start-up and sm
all firms, w
ith no earningsexpected in the near future, that raise m
oney on financial markets
If the evidence suggests anything, it is that markets do not value
current earnings and cashflows enough and value future earnings
and cashflows too m
uch.•
Low
PE stocks are underpriced relative to high PE
stocks
The m
arket response to research and development and
investment expenditure is generally positive
Asw
ath Dam
odaran36
Market R
eaction to Investment A
nnouncements
Type of A
nnouncement
Abnorm
al Returns on
Announcem
ent Day
Announcem
ent Month
Joint Venture Form
ations0.399%
1.412%
R&
D E
xpenditures0.251%
1.456%
Product Strategies0.440%
-0.35%
Capital E
xpenditures0.290%
1.499%
All A
nnouncements
0.355%0.984%
Asw
ath Dam
odaran37
IV. F
irms and S
ociety
In theory: There are no costs associated w
ith the firm that cannot be
traced to the firm and charged to it.
In practice: Financial decisions can create social costs and benefits.•
A social cost or benefit is a cost or benefit that accrues to society as a
whole and N
OT
to the firm m
aking the decision.–
-environmental costs (pollution, health costs, etc..)
–Q
uality of Life' costs (traffic, housing, safety, etc.)
•E
xamples of social benefits include:
–creating em
ployment in areas w
ith high unemploym
ent
–supporting developm
ent in inner cities
–creating access to goods in areas w
here such access does not exist
Asw
ath Dam
odaran38
Social C
osts and Benefits are difficult to
quantify because ..
They m
ight not be known at the tim
e of the decision (Exam
ple:M
anville and asbestos)
They are 'person-specific' (different decision m
akers weight them
differently)
They can be paralyzing if carried to extrem
es
Asw
ath Dam
odaran39
A H
ypothetical Exam
ple
Assum
e that you work for D
isney and that you have an opportunity toopen a store in an inner-city neighborhood. T
he store is expected tolose about $100,000 a year, but it w
ill create much-needed
employm
ent in the area, and may help revitalize it.
Questions:
•W
ould you open the store?
Yes
No
•If yes, w
ould you tell your stockholders and let them vote on the issue?
Yes
No
•If no, how
would you respond to a stockholder query on w
hy you were
not living up to your social responsibilities?
Asw
ath Dam
odaran40
So this is w
hat can go wrong...
STO
CK
HO
LD
ER
S
Managers put
their interestsabove stockholders
Have little control
over managers
BO
ND
HO
LD
ER
SL
end Money
Bondholders can
get ripped off
FINA
NC
IAL
MA
RK
ET
S
SOC
IET
YM
anagers
Delay bad
news or
provide m
isleadinginform
ation
Markets m
akem
istakes andcan over react
Significant Social Costs
Some costs cannot be
traced to firm
Asw
ath Dam
odaran41
Traditional corporate financial theory breaks
down w
hen ...
The interests/objectives of the decision m
akers in the firm conflict
with the interests of stockholders.
Bondholders (L
enders) are not protected against expropriation bystockholders.
Financial markets do not operate efficiently, and stock prices do not
reflect the underlying value of the firm.
Significant social costs can be created as a by-product of stock pricem
aximization.
Asw
ath Dam
odaran42
When traditional corporate financial theory
breaks down, the solution is:
To choose a different m
echanism for corporate governance
To choose a different objective:
To m
aximize stock price, but reduce the potential for conflict and
breakdown:
•M
aking managers (decision m
akers) and employees into stockholders
•B
y providing information honestly and prom
ptly to financial markets
Asw
ath Dam
odaran43
An A
lternative Corporate G
overnance System
Germ
any and Japan developed a different mechanism
for corporategovernance, based upon corporate cross holdings.•
In Germ
any, the banks form the core of this system
.
•In Japan, it is the keiretsus
•O
ther Asian countries have m
odeled their system after Japan, w
ith family
companies form
ing the core of the new corporate fam
ilies
At their best, the m
ost efficient firms in the group w
ork at bringing theless efficient firm
s up to par. They provide a corporate w
elfare systemthat m
akes for a more stable corporate structure
At their w
orst, the least efficient and poorly run firms in the group pull
down the m
ost efficient and best run firms dow
n. The nature of the
cross holdings makes its very difficult for outsiders (including
investors in these firms) to figure out how
well or badly the group is
doing.
Asw
ath Dam
odaran44
Choose a D
ifferent Objective F
unction
Firms can alw
ays focus on a different objective function. Exam
plesw
ould include•
maxim
izing earnings
•m
aximizing revenues
•m
aximizing firm
size
•m
aximizing m
arket share
•m
aximizing E
VA
The key thing to rem
ember is that these are interm
ediate objectivefunctions.•
To the degree that they are correlated w
ith the long term health and value
of the company, they w
ork well.
•T
o the degree that they do not, the firm can end up w
ith a disaster
Asw
ath Dam
odaran45
Maxim
ize Stock P
rice, subject to ..
The strength of the stock price m
aximization objective function is its
internal self correction mechanism
. Excesses on any of the linkages
lead, if unregulated, to counter actions which reduce or elim
inate theseexcesses
In the context of our discussion,•
managers taking advantage of stockholders has lead to a m
uch more
active market for corporate control.
•stockholders taking advantage of bondholders has lead to bondholdersprotecting them
selves at the time of the issue.
•firm
s revealing incorrect or delayed information to m
arkets has lead tom
arkets becoming m
ore “skeptical” and “punitive”
•firm
s creating social costs has lead to more regulations, as w
ell as investorand custom
er backlashes.
Asw
ath Dam
odaran46
The S
tockholder Backlash
Institutional investors such as CalPE
RS and the L
ens Funds havebecom
e much m
ore active in monitoring com
panies that they invest inand dem
anding changes in the way in w
hich business is done
Individuals like Michael Price specialize in taking large positions in
companies w
hich they feel need to change their ways (C
hase, Dow
Jones, Readers’ D
igest) and push for change
At annual m
eetings, stockholders have taken to expressing theirdispleasure w
ith incumbent m
anagement by voting against their
compensation contracts or their board of directors
Asw
ath Dam
odaran47
The H
ostile Acquisition T
hreat
The typical target firm
in a hostile takeover has•
a return on equity almost 5%
lower than its peer group
•had a stock that has significantly under perform
ed the peer group over theprevious 2 years
•has m
anagers who hold little or no stock in the firm
In other words, the best defense against a hostile takeover is to run
your firm w
ell and earn good returns for your stockholders
Conversely, w
hen you do not allow hostile takeovers, this is the firm
that you are most likely protecting (and not a w
ell run or well m
anagedfirm
)
Asw
ath Dam
odaran48
An U
pdate in 2002: The P
ower of S
tockholderP
ressure - The M
ost Improved B
oards
CE
ND
AN
T: M
oved to upgrade governance after an accounting scandal in 1998 and a lawsuit
settlement in 1999. Shareholders now
approve all stock-option plans for top execs. External auditors
are barred from consulting w
ork. Severance deals were curtailed. T
he board pushed to eliminate
staggered board elections after a shareholder proposal failed.L
UC
EN
T: G
ets low m
arks from governance experts because of a $679 m
illion revenue restatement
and a $200 billion loss in market cap since D
ecember, 1999. Perform
ance is still in the tank, but thecom
pany has taken steps to improve governance. T
he six-mem
ber board has a lead independentdirector. C
onducts annual self-evaluations. Meets privately w
ith internal and external auditors. Has
added two independent directors and has plans for three m
ore.C
OM
PU
TE
R A
SSOC
IAT
ES
: Having landed on the W
orst Boards list tw
o years ago for awarding
top execs a massive pay package, this com
pany has made im
provements. It hired H
arvard's JayL
orsch to advise it on governance, then put him on the board; recruited form
er SEC
chief accountantW
alter P. Schuetze for its audit comm
ittee. Prohibits directors from selling stock until they leave.
WA
LT
DISN
EY
: Finally taking steps to improve a reputation for lousy governance. U
nder pressurefrom
director Stanley P. Gold, m
anager of the Disney fam
ily fortune, and other shareholders, thecom
pany has severed business relationships with tw
o directors. Tightened board's definition of
independence. Recruited governance expert Ira M
illstein to advise board.W
AST
E M
AN
AG
EM
EN
T: A
fter emerging from
an accounting scandal in 1998 and acquisition byU
SA W
aste in the same year, the com
pany has reformed. E
ight new m
embers, all independent, are
on the nine-mem
ber board, and the audit comm
ittee is headed by Jack Pope, former C
FO at U
nitedA
irlines and Am
erican Airlines. Side deals betw
een directors and company are banned. A
nti-shareholder governance policies, including staggered board elections, are changed.
Asw
ath Dam
odaran49
The B
ondholders’ Defense A
gainst Stockholder
Excesses
More restrictive covenants on investm
ent, financing and dividendpolicy have been incorporated into both private lending agreem
entsand into bond issues, to prevent future “N
abiscos”.
New
types of bonds have been created to explicitly protectbondholders against sudden increases in leverage or other actions thatincrease lender risk substantially. T
wo exam
ples of such bonds•
Puttable Bonds, w
here the bondholder can put the bond back to the firmand get face value, if the firm
takes actions that hurt bondholders
•R
atings Sensitive Notes, w
here the interest rate on the notes adjusts to thatappropriate for the rating of the firm
More hybrid bonds (w
ith an equity component, usually in the form
ofa conversion option or w
arrant) have been used. This allow
sbondholders to becom
e equity investors, if they feel it is in their bestinterests to do so.
Asw
ath Dam
odaran50
The F
inancial Market R
esponse
While analysts are m
ore likely still to issue buy rather than sellrecom
mendations, the payoff to uncovering negative new
s about afirm
is large enough that such news is eagerly sought and quickly
revealed (at least to a limited group of investors)
As inform
ation sources to the average investor proliferate, it isbecom
ing much m
ore difficult for firms to control w
hen and howinform
ation gets out to markets.
As option trading has becom
e more com
mon, it has becom
e much
easier to trade on bad news. In the process, it is revealed to the rest of
the market (See Scholastic)
When firm
s mislead m
arkets, the punishment is not only quick but it is
savage.
Asw
ath Dam
odaran51
The S
ocietal Response
If firms consistently flout societal norm
s and create large social costs,the governm
ental response (especially in a democracy) is for law
s andregulations to be passed against such behavior.•
e.g.: Law
s against using underage labor in the United States
For firms catering to a m
ore socially conscious clientele, the failure tom
eet societal norms (even if it is legal) can lead to loss of business and
value•
e.g. Specialty retailers being criticized for using under age labor in othercountries (w
here it might be legal)
Finally, investors may choose not to invest in stocks of firm
s that theyview
as social outcasts.•
e.g.. Tobacco firm
s and the growth of “socially responsible” funds
(Calvert..)
Asw
ath Dam
odaran52
The C
ounter Reaction
STO
CK
HO
LD
ER
S
Managers of poorly
run firms are put
on notice.
1. More activist
investors2. H
ostile takeovers
BO
ND
HO
LD
ER
S
Protect themselves
1. Covenants
2. New
Types
FINA
NC
IAL
MA
RK
ET
S
SOC
IET
YM
anagers
Firms are
punishedfor m
isleadingm
arkets
Investors andanalysts becom
em
ore skeptical
Corporate G
ood Citizen C
onstraints
1. More law
s2. Investor/C
ustomer B
acklash
Asw
ath Dam
odaran53
So w
hat do you think?
At this point in tim
e, the following statem
ent best describes where I
stand in terms of the right objective function for decision m
aking in abusiness
Maxim
ize stock price or stockholder wealth, w
ith no constraints
Maxim
ize stock price or stockholder wealth, w
ith constraints on beinga good social citizen.
Maxim
ize profits or profitability
Maxim
ize market share
Maxim
ize Revenues
Maxim
ize social good
None of the above
Asw
ath Dam
odaran54
The M
odified Objective F
unction
For publicly traded firms in reasonably efficient m
arkets, where
bondholders (lenders) are protected:•
Maxim
ize Stock Price: This w
ill also maxim
ize firm value
For publicly traded firms in inefficient m
arkets, where bondholders are
protected:•
Maxim
ize stockholder wealth: T
his will also m
aximize firm
value, butm
ight not maxim
ize the stock price
For publicly traded firms in inefficient m
arkets, where bondholders are
not fully protected•
Maxim
ize firm value, though stockholder w
ealth and stock prices may not
be maxim
ized at the same point.
For private firms, m
aximize stockholder w
ealth (if lenders areprotected) or firm
value (if they are not)