Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
Business Finance Coursework « Market efficiency implies that ‘good’ investment decisions by managers should be translated into higher share prices. Share options could therefore be an effective way of reducing the agency problem, thus ensuring that managers make investment decisions which maximise the value of the business. »
The financial world is submitted under many theories which are not all compatible. Indeed, there are several schools of thought and they all use arguments which are both valid but contradictory. The statement that we are going to explain and critically evaluate could be rephrased like this: If the market efficiency exists, the value generated by a good investment should affect the price of the share. Moreover, if market efficiency theory appears to be real, the use of share options would create goal congruence between the interests of managers and owners of a company. In other words, it would reduce the agency problem. Indeed, in order to use their share options, the managers need to maximize the value of their business and that sticks to the strategy of shareholders’ wealth. In the statement, all the concepts are linked together and interdependent. For this reason, all along this essay we will go through this prior statement by providing a deep discussion of the key issues related. The very first area that we should explore is the concept of good investment and its relation with the share price fluctuation in the hypothesis of an efficient market. A good investment is “the purchase of a financial product or other item of value which produces favorable returns. In general terms, a good investment means making more money by the use of an initial amount”.1
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Online dictionary - http://www.investorwords.com/2599/investment.html - 3 December 2007
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Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
The statement highlights that in the case of an efficient market a good investment would directly affect the share price. However, the efficiency market hypothesis (EMH) has been the object of many discussions. The EMH propose to classify the market in three categories: weak form, semi strong form and strong form. The movement from weak to strong is related to the quality and quantity of information reflected by the share prices (historical information toward full information, that is to say historical plus public information and information internally owned). First of all, the EMH is a theory which has appeared in the 60’s and created by Eugene FAMA. In his thesis, he argues that important returns cannot be made on the market just by studying the information. For him, the share price is defined by the arrival of new information, which is by nature unpredictable. So, the price of a share is submitted to the random walk hypothesis. This hypothesis had enjoyed a lot of popularity and credibility before the eighties. Many empirical studies such as Kendall (1953), Fama (1965) or Alexander (1961) tend to confirm the random walk hypothesis. The differents tests used (serial correlation, run and filters) have highlighted very few linkages between past shares’ prices and current share’ prices: this is a proof that the weak form could exist. We should also say that the couple of links found and thus the potential abnormal return is balanced by the cost of transactions and taxes. Concerning the semi strong form, the works of Fama et al. (1969), Ball and Brown (1968) and Keown and Pinkerton (1981) tend to prove that the semi strong form could be valid. Finally, most of the specialists agree on the fact that the market could not be in a strong form because of the asymmetry of information between internal investors and external investors. But today and mainly since the eighties, that theory remains a simple hypothesis because many people believe that the markets could not be classified according to the models proposed by this hypothesis. Moreover, many studies have been carried out and tend to prove that EMH is irrelevant. Obviously, the relation between the share prices and the information has been intensely criticized. Some anomalies on the markets have been found and many researches were Page 2
Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
carried out on this area. Really strong arguments had brought to light the validity of such a hypothesis (EMH). According to those who argue that EMH is not realistic, the fact that the information is slow to be translated into a share price fluctuation proves that the markets cannot be efficient. Indeed, the first persons aware of this information could make abnormal profits in the short period of time between the realization of the good investment and its translation into a higher share price. For them, this proves that (at least) the Strong Form is very utopian. As an example we can speak about the Northern Rock Bank. As a follow up to the subprime crisis in the United States, the company borrowed money to the Bank of England in September 2007. Thus, the price of the share has not collapsed in few seconds, many days have been needed. Others criticize the power of the institutions such as banks, governments etc. Indeed, their power is so strong that they seem driving the share prices, that is to say having control on the shares’ prices. Their power in terms of buying capacity is so huge that their decisions influence the offer and demand. If they buy, the offer will decrease and therefore, the price of the share will go up. Conversely, if they sell, the offer will increase and the prices will go down. That argument is a fair critic of the whole Efficiency Market Hypothesis because every the potential forms is targeted. On this point, the best example that we can take is the recent American crisis of last summer about the subprime mortgage. Banks has experienced a need of liquidities and thus decides to liquidate their positions on different markets. As a consequence, the share prices dropped, which has had a devastating effect on many markets. In the recent years, another theory has often been opposed to the EMH: the Behavioral Finance. According to Haugen (1999), Shleifer (2000) and Barberis & Thaler (2002) the behavioral finance is a kind of psychology of the finance. Its argument is that in practice, some investors could take decisions which are against the maximization of their own profit. Thus on the long term and because of the me-too investors, this behavior could have an effect on the shares’ prices’ fluctuations. In the prior lines we have shown that the Efficiency Market Hypothesis presents some characteristics and evidences very convincing. But the detractors do not try to refute those arguments. They argue with completely different ideas. These undeniable findings are Page 3
Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
bringing to the mechanism of share price’s fluctuation a wider extent than the simple absorption of new information. According to the recent studies, the share prices movement would take into account a number of parameters such as the power of the financial institutions, or the behavior of the actors. However the previous theory about the relation between share price fluctuation and good investment is likely to be different in practice. Indeed, because many managers are assessed on their performance by the achievement of objective, some information are filtered and does not affect the share price. However, in the hypothesis where the market efficiency exists, it is widely discussed whether or not the use of share option could help to reduce the agency problem. Nevertheless, this kind of remuneration has recently begun to show its limits. So, the first thing that we should do is to explain the agency problem and the share option mechanism: •
The agency problem is the result of the interests’ divergence between shareholders and managers. Indeed, managers want to maximize the value of their own work (that is to say the profits) and pay dividends as little as possible. On the other hand owners want a maximization of their own wealth (that is to say the best return for their investment). The theory claims that the managers should work with a goal of shareholders’ wealth maximization. However, in practice, the things are different. The traditional system of remuneration is based on profits and reaching targets. Thus, the managers tend to optimize their results by hiding information to owners on purpose. As an example, they can minimize the incomes in order to reduce the dividends paid to shareholders.
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Concerning the share options, it is “A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.”2
In our statement, the share options and the agency problem are linked. Indeed, it has been claimed that the remuneration of the managers with share options of the company would improve the firm’s performances. 2
http://www.investopedia.com/terms/s/stockoption.asp
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Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
In theory and in order to benefit from such an option, the managers must improve the company’s share prices. Thus, they would be able to buy and sell the option and earn the money generated by the plus value. But to improve the shares’ prices, they need to take decisions which also fit the strategy of shareholders’ wealth maximization. This mechanism represents goal congruence between shareholders and managers’ interests. As a proof of its efficiency, we should remind that major companies, such as Intel Corp., Yahoo Inc., Oracle Corp., eBay Inc., Cisco Systems Inc. and Hewlett-Packard Co., are currently using share options. 3 The most positive effect of the share option is that it encourages managers to take risks. In order to maximize the benefits of the use of their options, they take risk that they would not take in normal times. This is a good point for the shareholders because they are seeking this risk. From their point of view, that risk is acceptable because they have a diversified portfolio. But in practice, the use of this kind of remuneration has been less efficient than in theory. Firstly, this theory can work only if the EMH exists. In order to profit of the share options, the managers need to maximize their influence on share prices. In other words, to make the use of share options efficient, the shares’ prices fluctuations must reflect only the information of the company (historical values, public and private information). But as discussed before, the share price could reflect information which might be external to the company (investments by institutions, behavioral finance…). Thus, as a result, a manager which has done a good job can see all its efforts being destructed by a negative market trend and then affect their motivation. Secondly, in the nineties a new argument has arisen. The famous accounting scandals such as Enron, WorldCom or Global Crossing have driven the attention to the accounting manipulation. The markets (especially in the US) have suffered of an important lack of confidence. For this reason the governments have created new accounting rules to improve the transparence of the financial statements. Those new rules set up a special treatment for the remuneration by share options: from now on, it needs to be accounted on the income 3
Companies reassess stock-option grants - Carolyn Said - San Francisco Chronicles
http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2006/08/27/BUGINKOHHO1.DTL
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Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
statement. As a consequence that affects the benefits of the company. Therefore, the Earnings Per Share is declining and it is translated in a decrease of the share price. So, a practice which is supposed to maximize the shareholders wealth ended up in the opposite effect. In addition, concerning the Earnings Per Share, it has also been said that the use of share options can help the accounting manipulations. Indeed, if there is a drop in the demand, the implementation of a new option award program could help reduce the wages costs and thus stabilize the Earning Per Shares.4 Finally, another important singularity of the share option is that it could make the managers overpaid. Indeed the fluctuation can produce huge returns for share option holders. Indeed, because of the anomalies about the EMH, we can say that a manager is rewarded regardless of the quality of his job. That could create some tension between investors and shareholders. Moreover, shareholders could become less efficient because they could tend to spend more time to managing their own money rather than doing their job. A striking example is Terry Semel, former CEO of Yahoo. He has recently quit his job at yahoo after 5 years of service. In 2006 his pay in stock options was $25.7 million during which time Yahoo!'s stock fell 35 per cent. 5
As a conclusion, I would like to quote the comment of an American economist famous for his work on portfolio theory, Mr Roll (1997): "EMH (is) one of the most controversial and well-studied propositions in all the social sciences. It is disarmingly simple to state, has far-reaching consequences for academic pursuits and business practice and yet is surprisingly resilient to empirical proof or refutation. Even after three decades of research and literally thousands of journal articles, economists have not yet reached a consensus about whether markets - particularly financial markets - are efficient or not"
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http://www.investopedia.com/terms/s/stockoption.asp
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COMPANIES INTERNATIONAL: Bonus of $25.7m for Yahoo chief - By Kevin Allison in San Francisco, Financial Times http://search.ft.com/ftArticle?queryText=terry+semel+share+options&aje=false&id=070306000748&ct=0 AND Terry Semel: the bloggers' verdict - Rhys Blakely - June 19, 2007 http://business.timesonline.co.uk/tol/business/industry_sectors/technology/article1954339.ece
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Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
To my mind, I think that the Efficiency Market Hypothesis omits one important part of the financial world: the external factor. It has appeared that the EMH takes into consideration only the information about the company. But recent theories such as the behavioral finance prove that external factors must be taken into account. Moreover, I agree the behavioral finance theory on the point that the financial markets are not free from incompetent persons, and thus that some investors can be irrational. For me, this concept irrationality is the most powerful critic and argument against the EMH. Indeed, we are unfortunately not living in a perfect world. That leads me to say that I neither believe the strong form of the EFH in any manner. For me, I do believe that the share prices reflect some information. But I do not want to argue that it is the essential influence. In my opinion, there is such a huge amount of factors which could possibly affect the fluctuations that we will never be able to find them all, find their inter-relations and the weighting of their respective influences. Concerning, the share options, I believe that the owners need to be very careful with their use. For sure, on one hand it creates goal congruence between shareholders and managers. But if (as I do) we believe that the markets cannot be completely efficient, it means that the managers don’t have a significant power on the share price fluctuations. Thus, in a recessionary period, they can be punished by the worthlessness of their options while they have achieved an outstanding work. Moreover, the recent changes in the accounting regulation make this remuneration method really dangerous for the firm’s benefits. To finish, I also think that most of the managers just use their option and sell the share in the same time. So a share option is a kind of short/middle term strategy whereas shareholders are working for a long term strategy. So, it would be interesting to find a way of obligating the managers to hold the shares purchased with the share options.
TOTAL WORD COUNT -2503-
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Brice BOUVIER – Student No. 07155935 Business Finance Coursework – 2007/2008
BIBLIOGRAPHY Corporate Finance, Principles & Practice - 4th edition - Denzil Watson and Antony Head – Prentice Hall Jane Fletcher - Lecture 2, Business Finance - University of Hertfordshire - 2007/08 Online dictionary - http://www.investorwords.com/2599/investment.html - 3rd December 2007 http://www.investopedia.com/terms/s/stockoption.asp COMPANIES INTERNATIONAL: Bonus of $25.7m for Yahoo chief - By Kevin Allison in San Francisco, Financial Times http://search.ft.com/ftArticle?queryText=terry+semel+share+options&aje=false&id=070306000748& ct=0 Terry Semel: the bloggers' verdict - Rhys Blakely - June 19, 2007 – The times http://business.timesonline.co.uk/tol/business/industry_sectors/technology/article1954339.ece What every financial manager needs to know about market efficiency - Dr Peter Atrill - 24 Feb 2002 http://www.accaglobal.com/students/publications/finance_matters/archive/2002/50/434077 Behavioral Finance and Investor Governance - LAWRENCE A. CUNNINGHAM - Washington & Lee Law Review, Vol. 59, p. 767, 2002 http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID255778_code010123530.pdf?abstractid=255778&m irid=1 The Efficient Market Hypothesis on Trial: A Survey - Philip S. Russel and Violet M. Torbey http://www.westga.edu/~bquest/2002/market.htm The Efficient Market Hypothesis & The Random Walk Theory http://www.investorhome.com/emh.htm On credit watch - THE WORLD ECONOMY – the economist http://www.economist.com/specialreports/displaystory.cfm?story_id=9972531 French Economy magazine – Challenges – August, 10th 2007 http://www.challenges.fr/20070810.CHA8777/les_cours_du_petrole_toujours_en_baisse.html The Controversy Over Option Compensations - Rick Wayman http://www.investopedia.com/articles/analyst/091202.asp Companies reassess stock-option grants - Carolyn Said - San Francisco Chronicles http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2006/08/27/BUGINKOHHO1.DTL
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