Sunday, July 19, 2009

Behavioral Corporate Finance 1: 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.


Johnny said...

Hi Prof Damodaran,

This is out of topic actually, when you will released the 3rd edition of Applied Corporate Finance and the book that u have learned, unlearned and relearned from the market crisis.

For 3rd edition of Applied Corporate Finance, u mention that u included the behavioral CF. Are u spread it into the all relevant topics in 2nd edition or u separated it into 1 topic.

Aswath Damodaran said...

It is at the printer already and should be reaching bookstores in a few months. As for behavioral finance, it will be integrated into all of the topics, rather than treated as a separate topic.

Steve Nunez said...

Interesting to read about decision making from the perspective of behavioural finance. There's been a gradual migration in thinking in the traditional BRMS (Business Rules Management System) space from one of managing rules to managing decisions. Many of those ideas mirror those you've outlined in this posting.

Perhaps decision management has finally come of age.

Steve Nunez

Jaffar said...


In the investor feedback model you describe, which investor group do you think would have "more reliable" feedback: institutionals or the retail investor crowd? Which group would you view as more credible as a manager seeking long term firm value?

For a suitable collection of publically held firms, it would be interesting to analyze the difference between fundamental firm value (DCF) and market value, as a function of institutional ownership %. Is there some magic percentage at which, one would get the most reliable value maximizing information or is the % completely irrelevant?


India Medical Tourism said...


What you have said definitely helps in making corporate decisions but as you have said it may not yield the desired result and the market may not behave the way we are assuming it to be and the decision of even issuing warrants boomerang as the issue would be dependent on too many variables like the conversion price, coupon rate, etc and while avoiding to decide on one thing may lead the company end up deciding on so many variable which might affect the price of their stock in the long run.

Immortal said...

i really would like to know how this process would materialize if applied....basing business decision on mkt response looks unrealistic as there wud be conflict of interest in views adopted by different set of investors...


Fresbee said...


It is a pleasure reading you not just in the textbooks but online as well. Keep the good work.
I replied to your post on Soros. Hope you had a chance to read it.


Unknown said...

A good principle for a manager of a company is to attempt to maximize returns with a minimum of risk. Return on equity is an excellent metric, other others can be used. By risk, I mean permanent loss of capital, not variance or volatility. The business should see a resulting increase in book value over time (adjusted for any dividends that may be paid). The manager, with any necessary assistance of his team, should be an expert in making the business decisions necessary to maximize returns and minimize risk.
A manager should never allow the business decisions to be influenced by fluctuations in the stock price of the company. The only consideration should be the wisdom of the business decisions themselves, their pros and cons. Fluctuations in market price appear crazy – watch the bid/ask and the purchase prices and you will see prices often bouncing around like made, many times without any rhyme or reason or any new information.
It would be a very bad reflection on a company to me, and cause me to value the company less, if a business manager used fluctuations in stock prices to influence his business decisions, instead of being able to rely on his own judgments of the pros and cons, and/or that his team, to make business decisions.
Of course, the manager should always be ready to change or modify a decision if it becomes clear through someone, investors included, that the decision is not the best for the company. However, this would involve raising concerns about flaws in the decision that, when considered, by the manager cause him to change his mind. It should not be as a result of mere fluctuations downward in the price of the stock. (As an investor, I am not going to change my valuation of a company merely because the pricethe stock is selling at has gone down. )

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