The Capital Asset Pricing Model (CAPM) has been the predominant model of risk and return taught in universities and business schools worldwide since the 1970s. At the same time, it has also become the predominant model used to estimate firms’ cost of (equity) capital. According to surveys, between 75 and 90 percent of CFOs and valuation professionals use the model.
However, it is also well known that the CAPM does not fit the data very well. Indeed, according to a forthcoming paper by Assistant Professor Clemens Otto and his collaborators, the widespread use of the CAPM has led to significant valuation errors for 12,000 takeover bids for private targets between 1977 and 2015.
The researchers found valuation errors corresponding, on average, to 12 to 33 percent of the deal values.
These valuation errors resulted in significant corresponding (bidder’s) stock price reactions when the deals were announced.
“We teach the CAPM and people use it in practice,” said Professor Otto, an Assistant Professor of Finance at the Lee Kong Chian School of Business. “Yet at the same time, we know it doesn’t perform so well. So then, the next step for us is to realise that this should have implications.”
These findings should concern managers and shareholders of companies on both sides of a takeover, he said.
Critiquing a widely used financial tool that almost everyone in the industry uses is all in a day’s work for Assistant Professor Otto, whose wide-ranging research covers financial contracting, financial reporting and disclosure, executive compensation, and behavioural finance.
He has a knack for finding interesting perspectives. In “CEO Optimism and Incentive Compensation”, which was published in 2014 in the Journal of Financial Economics, he discovered that CEOs with a more optimistic outlook tend to receive lower pay than their peers.
Using data on compensation in US firms, he provided evidence that CEOs whose option exercise behaviour and earnings forecasts are indicative of optimistic beliefs receive smaller stock option grants, fewer bonus payments, and less total compensation than their peers.
These findings showed the interplay between managerial biases and remuneration and also demonstrated how sophisticated principals can take advantage of optimistic agents by appropriately adjusting their compensation contracts.
He also has a 2020 paper “Accounting Quality and Debt Concentration” forthcoming in The Accounting Review, which examines the relationship between accounting quality and debt concentration in corporate capital structures. Assistant Professor Otto and his collaborators found that higher accounting quality is associated with less concentrated debt structures.
His numerous papers on different aspects of corporate finance might paint him as the stereotypical business school professor. However, he was not always an academic; before moving to academia, he worked as a management consultant.
He had attended Cologne University in the early 2000s where he studied Business Economics and International Management.
“The natural path would have been to work in a company after university,” he said. “It’s a common thing to do internships during your studies, and to try out what you may like or not like. And that’s what I did.”
He then worked as a management consultant with the Boston Consulting Group in Cologne between 2006 and 2007.
“[BCG] is a fantastic company and a great job. But the typical setup meant having many, many small problems to address in a limited amount of time,” he said. “With clients and time pressure, it is often more desirable to find a good solution, say an ’80 percent’ solution, quickly than to find the perfect solution in a longer time.”
“I enjoy academia because if a difficult problem takes a lot of time to address, you get that time. You can look for the complete, ‘100 percent’ solution. That is something I find particularly attractive. At the end of the day, I enjoy thinking about complicated questions to which I don’t know the answers, and academia affords me the time and the resources to do that.”
After leaving BCG, he went to do his Master of Research and PhD in Finance at the London Business School, before joining HEC Paris from 2012 to 2017. He then joined the Lee Kong Chian School of Business.
He and his wife are both academics and had been interested to move to Asia as a family. They viewed SMU as one of the top universities in Asia, and as fate would have it, they both ended up joining SMU as faculty.
Assistant Professor Otto has now been living in Singapore for more than three years. His impression of Singapore as clean, safe, well organised and efficient, formed in 2007 on his first-ever visit here, has not changed.
“These are certainly all attributes a German can appreciate,” said the father of two, who also enjoys the diverse food options that Singapore offers.
He said he likes teaching students here. However, unsurprisingly, there are cultural differences. Assistant Professor Otto noted that his personal communication style may be more direct compared to others.
Regarding the students, “I would wish for them to be a bit more outspoken and to develop and discuss their own, critical views,” he said.
