Monday, September 18, 2006

Do CEOs ever have a responsibility to "talk down" the share price of their company?

Talking down the share price of the company you are responsible for can often invoke an incendiary reaction from incumbent shareholders, especially if you have yet to build up the almost religious cult following that Warren Buffett has. And if you haven’t, doing so either takes

i. a strong sense of moral courage,
ii. a questionable sense of ethics,
iii. questionable business judgment, or
iv. a very good utilitarian reason to do so.

Talking Down in an Efficient Market

Assuming an efficient market, one can consider three main reasons why a CEO would want to talk down his company’s share price.

1. Public information does not reflect inside information

Under the information perspective for decision usefulness, markets respond rapidly and rationally to newly released public information. This means that market value diverges from intrinsic value only if public information does not reflect inside information, and the market has over optimistic expectations of the firm’s performance based on public information that does not give an accurate picture of the company’s inner workings.

When this happens, CEOs have an interest in ‘talking down’ their share price and releasing accurate inside information to the public, in order to manage shareholders’ expectations. The risk for the CEO is that the company will report future earnings that are below shareholders’ expectations that were based on faulty information. This could result in adverse consequences for the CEO’s job or compensation. This also allows the public to have better information of the internal state of the company, and avoids an over-allocation of capital to the company’s shares by the capital market.

2. The CEO wants to reduce expectations to make future performance seem better than it really is

Assuming public information more or less reflects the inner workings of the company, a CEO might be motivated to talk down the share price by making the company appear to be in worse condition than it really is, in order to make future earnings results seem abnormally high. A CEO stands to benefit financially from this practice when earnings performance is higher than expected, but doing so is ethically questionable, since it essentially involves deceiving shareholders and the market.

3. The CEO’s judgment is inaccurate

If public information is congruent with inside information, then a third reason why an honest CEO might want to talk down his company’s share price is because he has an overly pessimistic assessment of the company’s prospects. The converse is true if he tries to talk up share price in an efficient market with little information asymmetry – the CEO may be over estimating the prospects of his company. This is probably much more prevalent in practice.

Talking Down in an Inefficient Market

If, however, public information does accurately reflect inside information, and if a CEO is not prone to questionable ethical behaviour, then one has to consider relaxing the efficient market assumption in order to find reason to talk down the share price. With the advent of new fields of study like behavioural finance and comments of ‘irrational exuberance’ by such luminaries as Alan Greenspan, this may not be such an outrageous relaxation of assumptions after all. In fact, assuming that the market may not be efficient relaxes the need to assume that either:

a. information asymmetry exists,
b. a CEO is behaving unethically, or
c. a CEO’s judgment is inaccurate,

or any combination or permutation of the three.

Assuming public information reflects inside information, a CEO is honest and behaves with integrity, and the CEO accurately understands the value of his company, a CEO would be motivated to talk down the share price of his company if he noticed that the stock of his company was trading at a price significantly above its intrinsic value.

Doing so would:

i.Protect current shareholders from having an inflated sense of their wealth.
ii.Prevent a transfer of wealth, rather than a creation of wealth, from those buying the shares at the inflated price to those selling the shares at the inflated price. This is particularly important if we hold that prices eventually correct to reflect a company’s intrinsic value. When that happens, many retirement funds and children’s college funds can be destroyed overnight when share prices fall from lofty heights.
iii.Prevent the CEO & management team from being the victim of unrealistic expectations that are imputed into an inflated share price.
iv. Encourage efficient allocation of capital in the stock markets.

The very idea of an inefficient market, however, suggests that efforts by a CEO to persuade the market to 'rationalise' its pricing may well be unsuccessful. There is a significant chance that an inefficient market with irrational participants will ignore the talking down of the CEO, since the market has already ignored the public information available and has mispriced the company's stock.


Whether or not one believes the market is efficient, there are times when a CEO is rightfully motivated to talk down the share price of a company. And none other than Warren Buffet and Charles Munger "like the stocks of both Berkshire and Wesco to trade within hailing distance of what [they] think of as intrinsic value. When it runs up, [they] try to talk it down. That's not at all common in Corporate America, but that's the way [they] act." And if shareholders can suspend their immediate reactions of unhappiness towards such a move, they might well find that the CEO's actions are in the long run interests of the company as a whole.



Kerin, Paul (2006), "Tactical Retreat," Business Review Weekly
Scott, William R. (2006), Financial Accounting Theory, Person Prentice Hall
Tilson, Whitney (2003), "Charlie Munger's Worldly Wisdom," The Motley Fool

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