1. Behavioral Corporate Finance A book review by Lynn Sears, CMA
Abstract: Shefrin, Hersh. Behavioral Corporate Finance. Decisions that Create
Value. New York: McGraw Hill 2007. Abstract: The author presents psychological
factors that affect business decisions and illustrates how these factors can
adversely impact the financial health of businesses. He uses numerous examples
derived from the experiences of well known companies. Additionally, he gives
advice on how to avoid the problems these factors may cause.
Behavioral Corporate Finance begins by defining major biases such as
overconfidence and excessive optimism. Successful companies are especially prone
to these biases since past accomplishments can give a manager the illusion of
having greater control over a situation as well as unrealistically high expectations
for favorable outcomes. Managers who experience past success believe their
abilities to be greater than they really are and are susceptible to hubris i.e.,
arrogance and pride. These attributes also lead to a higher likelihood of
overestimating rates of return, leading to overstated sales forecasts and
understated budgeted costs.
The author provides the example of Scott McNealy, CEO of Sun Microsystems.
Abundant personal and professional success coupled with the dramatic increase in
Sun’s stock price circa 2000 made him excessively optimistic, overconfident and
cocky which led him to believe that the recession of 2001 would not last as long as
expected. These attributes also caused McNealy to underestimate the market for
cheaper servers. He failed to recognize decreased demand for Sun’s products, and
he increased investment in new projects without sufficient projected revenue to
support them.
McNealy was also plagued by confirmation bias, turning a blind eye toward data
that does not confirm ones’ gut feelings. This manifested itself in his reluctance to
implement cost cutting measures during the recession, mainly because he didn’t
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2. take into account the historical cyclical trends that show the duration of a typical
economic downturn.
Several other biases relating to data interpretation can come into play.
Representativeness, the reliance on stereotypes; and the affect heuristic, using
intuition instead of methodical research and analysis; can skew financial analysis
thereby creating a shaky foundation for a decision. Extrapolation bias, placing more
importance on recent events as a way of predicting outcomes, is also known as the
hot hand fallacy. Investors will be more optimistic when the market is good and
may perceive recent winners to be less risky than recent losers. Not surprisingly,
losses have far greater psychological impact than gains.
In Chapter 4 Shefrin discusses the correlation of risk and return. Traditional
finance theory holds that a risky stock generates a higher return because an
investor requires higher compensation for accepting risk. Representativeness
affects an investor’s perception of the correlation of risk and return because the
average investor sees a less risky stock as a ‘better’ stock. Shefrin defines “better’
as a stock with a higher return. Shefrin illustrates his point with a comparison of
Intel and Unisys and a survey’s conclusion that investors thought Intel was a better
stock. But was it representativeness that led to the conclusions? Investors looked
at the beta and other stats below but according to Shefrin they favored Intel since
it’s a better known company. Of course Intel is a better stock. Look at the
companies’ retained earnings and rates of return. This reader believes that it is also
reasonable to expect the probability of loss to be greater with a higher risk stock,
and that volatility of earnings would ultimately affect long term rates of return.
Unisys has a slightly higher 3 year rate of return but it is not enough to justify the
risk of investing in a company with a $1.53 billion retained earnings deficit. While
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3. we can’t overlook traditional finance theory, many investors are too risk-adverse to
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choose a stock such as Unisys.
Unisys Intel
Beta 1.33 1.04
Market Value of Equity ($ Billion) $8.00 $441.86
Book Value of Equity ($ Billion) $2.088 $36.10
Book to Market Equity 0.26 0.08
Balance Sheet Retained Earnings ($
Billion) ($1.62) $25.22
Prior 6 mo return -67.60% 215.60%
Prior 1 year return 92.80% 222.30%
Prior 3 year return 60.20% 56.20%
Past 5 year growth rate of sales 0.80% 21.20%
Chapter two contains a detailed missive on Security Analyst Mary Meeker’s
analysis of EBay. Shefrin adeptly demonstrates that her work was flawed due to
framing biases2 as well as unsound, unsystematic methods of calculation. The
absence of important metrics such as return on equity or cost of capital can be
disastrous, and many analysts rely on more intuitive forms of valuation because
they are simpler than traditional calculations. While it is true that Meeker’s work
was sloppy, Shefrin’s argument would be more substantial were it not for the fact
that Meeker’s work did in fact produce an upside adjusted average target price of
$106 (however flawed the underlying method was) for the EBay stock, compared
3
to the actual closing price on 8/29/03 of $109.52.
Shefrin presents an interesting discussion on initial public offerings (IPO’s) and
the use of capital to drive his point home regarding the perception of opportunity
1
Shefrin, Hersh. Behavioral Corporate Finance – Decision that Create Value New York:
McGraw Hill 2007. page 59.
2
A Framing Bias will unfairly influence a decision due to the manner in which the data is
presented.
3
IBID, page 25.
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4. costs4 and agency conflicts5 at work in stock valuation. He cites a stunning example
of VA Linux. The underwriters’ fee in an IPO is based on a percentage of the total
offering. This can lead to under-pricing of stock. Further, agents are motivated to
encourage a low initial stock price since they can offer the low priced stock to
favored clients. In this way the agents benefit indirectly by the enhanced
relationship with those clients. When VA Linux Systems went public in December
1999, 4.4 million shares were issued at $30 each and in doing so raised $132
million. But at the end of that day the stock closed at $239.25, giving investors who
got in on the ground floor a return of 698%. Not bad for a day’s work! While on one
hand, VA Linux’ management felt good at having raised $132 million, on the other
hand, by mispricing the stock, they actually lost $920.7 million. The monetary gain,
$132 million, obscured the $920.7 opportunity cost because human nature allows
us to experience an out-of-pocket loss and a ‘real’ gain much more intensely than
an opportunity cost.6
A conflict will exist between short term and long term results. Managers forego
opportunities to the detriment of the firm when faced with cash shortages and
earnings pressures, particularly in the areas of capital budgeting and manipulation
of earnings per share. These firms may be unable to invest in research and
development or capital equipment. These short sighted decisions will limit future
revenue streams since failure to invest in worthwhile capital projects and research
and development inhibits a firm’s ability to create new products, improve existing
manufacturing processes, and otherwise pursue new markets and opportunities.
4
An opportunity cost is an indirect cost (not out of pocket) that represents lost money due
to forgoing an opportunity.
5
An agency conflict is a conflict of interest arising out of individual’s interest not being
aligned with that of the company.
6
IBID, page 85-88.
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5. Escalation of commitment (throwing good money after bad) can bring financial
ruin to a firm. Managers are more willing to dump additional funds into a bad
project if there is already a sunk cost7. This is mainly done to avoid feelings of
regret and is particularly true if the project is highly visible. And it seems not to
matter if the manager’s compensation is tied to profits nor does it matter if the
manager is a shareholder, although Shefrin also points out in chapter eight that
there is too little difference in compensation between managers who perform poorly
and those who perform well. He also states that executives are overpaid and not
easily dismissed when they fail to perform. Companies that offer extravagant
perquisites such as the use of company jets for personal travel experienced on the
average, 4% less return on their stocks.
A cash-rich firm will pay dividends to ‘make a statement’. They will repurchase
stocks to enhance their stock’s value. Market timing is often a factor in this
decision. They face a conflict in choosing which investor to satisfy: the one who
desires dividends, or the one who prefers capital gains.
A cash-rich firm, or a firm with a low cost of capital, will be more likely to invest
in projects with lower rates of return since their hurdle rate is lower. Additionally,
they will invest ‘for the sake of investing’ because they have money to burn. This is
especially true for a firm that has experienced past profitability, since that makes
them more prone to hubris.
Shefrin uses the AOL Time Warner merger to demonstrate the overestimation of
synergy and inefficient market prices. AOL acquired Time Warner for $165 billion in
AOL stock at the height of the ‘technology bubble’, when tech stocks were
enormously inflated. AOL’s stock was overpriced and their CEO, Steve Case, was
well aware of it and saw the merger as an opportunity to protect AOL shareholders
7
A sunk cost is a cost that has already been incurred and is not likely to be recouped.
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6. by acquiring a more diverse, well-established firm. Although on the surface the
merger seemed beneficial to both companies due to AOL’s internet expertise and
the anticipated sharing of a customer base, the upshot was lower revenue,
incompatible cultures, and the loss of 80% of AOL Time Warner’s value. There was
ultimately a write-down of $54 billion in goodwill; the amount of overpayment
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attributable to inflated stock prices and an inefficient market.
Framing biases and anchoring and adjustment were prevalent in Hewlett
Packard’s acquisition of Compaq. During 2001 HP was losing market share to IBM
and its PC business was not profitable. Shefrin points out that they were operating
in the ‘domain of losses’ which psychologically made loss the point of reference,
meaning that even a small profit would be better than the current losing situation.
HP’s CEO Carly Fiorina needed to take action and began talking with Compaq.
She used the framing bias to convince the other board members to pursue the
acquisition of Compaq. She appealed to board members’ overconfidence and
induced them to be risk-seeking. Although psychological factors drove their
decision, there was also a potential for cost savings resulting from the synergy of
the two companies in terms of head count reduction, closing of manufacturing and
administrative facilities, and more efficient procurement. At first the cost savings
were on target and HP’s stock performed substantially the same as competitors IBM
and Dell. But earnings eventually fell below target and HP’s stock price declined.
Rather than rush into a merger to achieve unremarkable increases in revenue and
profits, HP should have objectively evaluated the printing segment of its business,
which turned out to be the most profitable and could have been expanded. By
8
Ibid, p.171
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7. spring 2004 that segment of the business contributed 30 percent of HP’s revenue
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and 80% of its profits.
Groupthink is a powerful dynamic at play in boardrooms that can set the stage
for inadequate sharing of information, an overriding desire to reach a consensus,
and unsound business decisions. This reader is reminded of her own personal
experiences with team projects in a company that continually overemphasized soft
skill building. Does the desire for everyone to ‘get along’ inhibit differences of
opinion that otherwise would be conducive to healthy debate and the ultimate
formulation of beneficial strategies? To avoid groupthink, Shefrin suggests inviting
outsiders to the meetings, have members play devil’s advocate, ask that people
refrain from stating their opinions until all sides of an issue are heard, and
encourage shared information as well as differing points of view.
The presence of human factors in all areas of our lives makes for fascinating
study. We tend to think of the business world as an objective, educated monument
to common sense, rational decision making processes, control, and logic. We
believe that the knowledge we acquire in institutions of higher learning, and in
valuable career experience, can help us navigate our companies to ever higher
levels of achievement. As Hersh Shefrin eloquently and capably teaches us, this is
not always the case, and ironically it seems much worse in firms that have attained
greatness in the past. This book is highly recommended to help us recognize the
behavioral pitfalls to which we are all vulnerable, and to take the appropriate
measures, which Shefrin provides in each chapter, to mitigate the effects of these
pitfalls and thus minimize the damaging results of poor decision making, and create
value and profit for the firm.
9
Ibid, page 176.
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