Governing Misvalued Firms

For decades, economists have argued that stocks can get priced irrationally and that this divergence from fundamental value may impact managerial decisions. If overvaluation leads to misbehavior and if strong governance curbs misbehavior, then governance should be particularly valuable in times of overvaluation. This simple yet powerful idea surprisingly has not been explored in the literature. In this paper, the authors fill the gap and ask whether strong corporate governance is especially important during periods of overvaluation when agency costs of managerial misbehavior are high. Results of joint tests of the perverse effects of overvaluation and the ability of governance to counteract them suggest that boards and shareholders looking to create long run value need to increase vigilance and oversight during times when the firm's stock is outperforming. This vigilance is especially important when CEOs have powerful pay-for-performance incentives. Key concepts include:

• The impact of governance is strongest during times when firms are highly valued.
• Overvaluation may cause or correlate with misbehavior. Better governance counters the misbehavior.
• It is important to combine strong pay-for-performance compensation with strong governance and to increase vigilance when firms may be overvalued.