Admittedly, few CEOs or CFOs ever admit their share price is too high — at least not out loud. Given all the time these executives spend generating investor interest in their stock, it would be very hard for them to ever see, much less say, it is overvalued. It would be like a Chevy salesman telling a customer that Ford is actually better.
We all know that stocks are sometimes undervalued and sometimes overvalued. This can be due to general market conditions, such as during the 1999 Internet bubble. With the benefit of hindsight we can see that most stocks were overvalued relative to how they are valued on average and over time.
Users of the same approach, however, undervalued most stocks during the credit crisis of 2009. The challenge is often recognizing this at the time. Overvaluation or undervaluation can also be applied to an industry or individual company that is running hot or cold.
It’s ironic that even when the overall market is hot, most senior executives tend to believe their own stock is undervalued. This belief is often reinforced by bankers who won’t even use the term “overvalued,” preferring instead to refer to companies using the code words “fully valued.”
This obsession with seeing your own shares as “cheap” leads to some unfortunate corporate actions. First and foremost is the propensity to buy back shares at the peak of the market. In the peak stock market year of 2007, the members of the S&P 500 index bought back $579 billion worth of their own stock, which was over 4.2 times as much stock as they repurchased in 2009 when the S&P 500 index hit a level that was 57 percent below the 2007 peak.
What should companies do if management suspects its share price might be overvalued? The following four actions can create value when the share price is high.
1. Use Your Stock to Make Acquisitions. Cash acquisitions usually don’t create value at the top of the stock market cycle. Our research shows that over the decade of the 2000s, the worst year for acquirer relative share price performance was 2007, when the market last peaked. The absolute price-to-book values paid were highest that year, even though the average premium paid above the price before the acquisition was below average.
The risk of overpaying is mitigated by exchanging your own potentially overvalued stock for the stock of the acquired company. This strategy can lead a company that believes they are particularly overvalued to actually seek acquisitions to take advantage of the high-valued currency their shares represent.
From an accounting point of view, stock deals still lead to the potential for very high goodwill because the acquisition price drives the determination of goodwill whether cash or stock is used. And in the next downturn, this goodwill may end up being written off. If this happens and there really is nothing wrong with the acquired company, then this write-off is just the recognition that the price paid was really much less than it seemed when valuations are normalized.