The Overvaluation Trap

When investor expectations are impossible to meet, bad behaviors ensue.

by

Roger L. Martin

and

Alison Kemper

by

Roger L. Martin

and

Alison Kemper

From the Magazine (December 2015) · Long read

Ryan Inzana

Summary.

In 2007, Chuck Prince, then the CEO of Citigroup, made a notorious comment about the subprime mortgage market: “As long as the music’s playing, you’ve got to get up and dance. We’re still dancing.” Soon after, the financial system crashed, and that remark came to be seen as a cavalier justification for excessive risk taking by the bank. But authors Martin and Kemper raise another possibility: Prince may have been painted into a corner, because Citigroup’s stock was indefensibly overvalued. The only way the bank could earn the unrealistically high returns shareholders expected was through ever more dangerous activities.

The overvaluation trap was first identified by Michael Jensen in a 2005 article examining the dot-com bubble. He noted that it often affects entire sectors and that in response to it executives tend to adopt two strategies: investing in hot, hyped technologies (as Global Crossing did with fiber-optic cable) and glamorous acquisitions (Nortel’s downfall). And when investment opportunities start to dry up, firms may turn to financial manipulation (think WorldCom) to prop up their overpriced equity.

Martin and Kemper point out that today companies in the pharmaceutical and oil sectors are caught in this same trap. Their market caps are spectacularly high. But massive spending on R&D is not producing more new drugs, and ever greater investment in oil reserve exploration is only exacerbating the glut of supply. The dance may be ending for both industries, and their executives need to figure out new and more-realistic narratives for value creation.

Idea in Brief

The Problem

CEOs of companies with high price-to-earnings ratios often make decisions that soon turn out to be deeply flawed. These missteps may have not only financial consequences but also environmental and social ones.

Why It Happens

Because of unrealistic investor expectations about a sector’s potential and what it takes to succeed. CEOs make moves that the market wants to see. Pricking the expectations bubble will only guarantee a sharp correction. But CEOs who play along may be able to move on before reality sets in.

Avoiding the Trap

CEOs should be more sensitive to the evidence about company prospects and develop strategies more consistent with that evidence.

On July 9, 2007, Chuck Prince, then the CEO of Citigroup, made a comment that was to become notorious: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince meant well. He wanted to reassure reporters in Japan that signs of weakness in the U.S. subprime mortgage market would not cause Citigroup, a major player in that market, to pull back from further lending there.

A version of this article appeared in the December 2015 issue (pp.102–109) of Harvard Business Review.

Roger L. Martin is a former dean of the Rotman School of Management, an adviser to CEOs, and the author of A New Way to Think (Harvard Business Review Press, 2022).
Alison Kemper is an assistant professor at Ryerson University.

The Overvaluation Trap

Idea in Brief

The Problem

Why It Happens

Avoiding the Trap

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