The Effect of Managerial Overconfidence on the Values of Equity and Firm: A Simulated Valuation Approach
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The corporate world has suffered a crisis of managerial overconfidence. In the United States and around the world, managerial overconfidence has been a key input of corporate decisions for decades. Managerial overconfidence affects how managers interpret the information they receive from various media and on- or off-line sources. Managerial overconfidence is particularly pronounced among managers of acquiring companies who face the difficult task of evaluating the takeover targets. The purpose of this article is to investigate the impact of managerial overconfidence on firm value through a valuation framework. To this end, we employ two conventional valuation models – the dividend discount model (DDM) and the free cash flow model (FCFM) - to reveal the valuation effect of managerial overconfidence. Simulated sensitivity analyses show that the propensity of firm value to managerial overconfidence changes rapidly when the degree of managerial overconfidence strengthens. The simulation results show that when the DDM is applied the overconfident value of equity is, on average, 4.5 times the non-overconfident value of equity. When the FCFM is simulated, the ratio of the overconfident value of firm to the non-overconfident value of firm becomes 9.9 times, a big jump from 4.51 times for the DDM case. Regardless of the evidence of its useful contributions, managerial overconfidence appears to be a value-destroying behavioral bias that needs to be properly and cautiously addressed in corporate and individual investments and in educational settings of finance and accounting.
Abstract
The corporate world has suffered a crisis of managerial overconfidence. In the United States and around the world, managerial overconfidence has been a key input of corporate decisions for decades. Managerial overconfidence affects how managers interpret the information they receive from various media and on- or off-line sources. Managerial overconfidence is particularly pronounced among managers of acquiring companies who face the difficult task of evaluating the takeover targets. The purpose of this article is to investigate the impact of managerial overconfidence on firm value through a valuation framework. To this end, we employ two conventional valuation models – the dividend discount model (DDM) and the free cash flow model (FCFM) - to reveal the valuation effect of managerial overconfidence. Simulated sensitivity analyses show that the propensity of firm value to managerial overconfidence changes rapidly when the degree of managerial overconfidence strengthens. The simulation results show that when the DDM is applied the overconfident value of equity is, on average, 4.5 times the non-overconfident value of equity. When the FCFM is simulated, the ratio of the overconfident value of firm to the non-overconfident value of firm becomes 9.9 times, a big jump from 4.51 times for the DDM case. Regardless of the evidence of its useful contributions, managerial overconfidence appears to be a value-destroying behavioral bias that needs to be properly and cautiously addressed in corporate and individual investments and in educational settings of finance and accounting.
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