Today’s Top Stories
- Major tech companies unite to call for new limits on surveillance (Business News, Financial News, Business Headlines & Analysis - The Washington Post)
- Riot spoils Singapore’s harmonious image (UK Homepage)
- EADS to cut up to 6,000 jobs (Europe homepage)
- EADS to cut up to 6,000 jobs (UK Homepage)
- Ex-Deutsche Bank exec guilty of bribery (Europe homepage)
- Ex-Deutsche Bank exec guilty of bribery (US homepage)
- Stocks firm on growth optimism (US homepage)
- Three dead in Bolton house fire (BBC News - Home)
- DJ Campbell held in fixing probe (BBC News - Home)
- North Korea Confirms It Has Purged Dictator's Uncle (WSJ.com: World News)
- Greece Forecasts First Round of Growth in Six Years (Business & Money | TIME.com)
Other Blog Headlines
- 10 Monday AM Reads (The Big Picture)
- Paul Krugman: The Punishment Cure (Economist's View)
- Sunday Night Futures: Taper Talk and "Small Ball" Budget Agreement (Calculated Risk)
- Twitter Digest: 2013-06-09 (Paul Kedrosky's Infectious Greed)
Category Archives: Corporate Strategy
The world recently lost a truly beautiful economic mind. I, along with many others, have been reflecting on Ronald Coase’s passing over the past several weeks, and I was truly saddened to read the news. His 1937 classic “Nature of the Firm” had a profound impact on my intellectual development and growth.
Coase is perhaps best known for “Coase’s Theorem,” which addresses economic efficiencies in the face of externalities. Coase argued that in a world without transaction costs, markets can efficiently allocate costs associated with externalities. Indeed, the system of “Cap and Trade” can be viewed as an attempt at Coasian bargaining by creating a market for externalities.
Though Coase’s Theorem has been influential in the realm of both economics and public policy, his contributions extend well beyond those domains. His work has been central to Business Strategy, and in particular, Corporate Strategy. What many often forget is that Coase was the intellectual founder of the field of Transaction Cost Economics. And as I explained in a blog post lauding Oliver Williamson as the Nobel recipient in Economics (see Oliver Williamson, Nobel Honoree):
Transaction Cost Economics is a central theory in the field of Strategy. It addresses questions about why firms exist in the first place (i.e., to minimize transaction costs), how firms define their boundaries, and how they ought to govern operations.
In Transaction Cost Economics, the starting point is the individual transaction (the synapse between the buyer and the seller). The question then becomes: Why are some transactions performed within firms rather than in the market, as the neoclassical view prescribes. The answer, not surprisingly, is because markets break down.
Coase recognized that there were costs to using the market mechanism (transactions costs) that resulted in market failure.
For these reasons [because of transactions costs] it is often more advantageous to structure transactions within firms. And this is why firms are not just ubiquitous in our society, but also worthy of study in their own right. This contrasts with the typical view of firms in neoclassical economic theory as, at worst, a market aberration that ought not exist, and at best, a black box production function.
Today, transaction costs economics is often used to explain corporate scope, and is widely applied to the study of growth and diversification – whether via organic growth, alliance, or acquisition.
All things considered, as a Strategy scholar, I feel truly fortunate to be able to stand on the shoulders of intellectual giants such as Coase.
The New York Times’ Dealbook recently highlighted Fiat’s offer of $198 million for 3.3% of Chrysler’s stock. Fiat, which currently owns 58.5% of Chrysler, is looking to consolidate ownership and further integrate its American subsidiary.
The offer implies an enterprise valuation of $6.7 billion for the entire firm. However, many, including the article’s author, believe that Chrysler is worth much more (see Valuing Chrysler Too Cheaply).
Mr. Marchionne’s offer values Chrysler at just four times his own expectation of the company’s 2012 net income. General Motors, meanwhile trades above nine times expected earnings for last year, and Ford Motor’s multiple is just over 10 times.
The Fiat proposal also pegs the enterprise value of Chrysler at $6.7 billion, scarcely more than the company’s $5.5 billion of…Ebidta…Ford’s enterprise value-to-Ebidta multiple is over five times; G.M.’s is just 2.6 times, partly thanks to $20 billion of net cash. That makes Mr. Marchionne look mighty cheap.
Sergio Marchionne, Fiat’s chief executive, admits that the offer might not be in line with Chrysler’s current performance. However, I am more interested in understanding why Fiat would undervalue Chrysler. Given Fiat’s current struggles, I can’t help but wonder if the real issue is that Fiat can’t afford to buy it anymore…
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Chrysler IPO (Wealth Daily, 9/17/13)
I recently read an article at the Baseline Scenario about CEO stars, CEO compensation, and firm performance (see One Hit Wonder). It is no secret that compensation packages for CEO’s are often quite lucrative. However, there is a common belief that CEO’s, as “star” executives, merit such compensation packages because they possess inalienable management skills that create value for shareholders. Moreover, the belief is that the managerial skills that “star” executives possess are transferable from one organization to another. For this reason, companies poaching CEO’s from one organization to another often lavish that individual with sweetheart deals. Such an outcome is rational if we believe that executive (CEO) compensation is the natural result of a competitive market for “talent,” and that the CEO will bring his or her talents to the new company, thereby increasing shareholder value.
However, James Kwak of the Baseline Scenario points out that there might not be such a tight coupling between pay and performance when star executives move from one company to another. According to a review of the academic literature on the topic by Charles Elson and Craig Ferrere (as summarized by Kwak),
Elson and Ferrere cite multiple empirical studies finding no relationship between a CEO’s performance at one company and his performance at the next company that massively overpaid to hire him. They conclude: “the empirical evidence suggests a negative expected benefit from going outside rather than pursuing an internal succession strategy, despite the ability to access an enhanced talent pool. In the aggregate, CEOs appear to be at their most effective only when they have made significant investments in firm-specific human capital.”
The argument is that “star” CEO’s lured from one company to another – i.e., the ones that everyone believes will succeed because they have succeeded in the past – don’t create value for the hiring company. Rather, it is likely that they appropriate most of the value that they generate by commanding higher pay packages than what should have been granted them. It is also quite possible that their “inalienable” management talent is not as “inalienable” as many believe. Otherwise stated, they are not as good as their pay suggests.
Although not in the context of CEO’s, Boris Groysberg (of Harvard) has a similar study of star analysts (see Chasing Stars: The Myth of Talent and the Portability of Performance). Like the CEO study, he finds that when star analysts move from one company to another, they usually under-perform and are overpaid for the privilege. They appropriate more value than they bring to the new company. In essence, they are likely not as good as most believe them to be, their prior performance depends upon the resources available to them at their former employer, and the teams they had in place while working for that company. In short, it’s less about individual, portable talent and more about a team of people working together.
I’ve written about executive compensation extensively in the past (see The Credit Crunch and Executive Pay, Revisiting Executive Pay, A New Approach to Executive Compensation and Are Managers Really Rational). I’ve previously pointed out other factors contributing to the complex issue of excessive compensation packages:
We can now add to that the “chasing stars” phenomenon.
Overall then, there are various reasons why executive compensation might not reflect such a “rational” process. And unfortunately, it is shareholders who end up bearing the real costs associated with any perversion in the compensation system.
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