Firm Value and Managerial Incentives: A Stochastic Frontier Approach

We examine the relation between firm value and managerial incentives in a sample of 1487 US firms in 1992-1997, for which the separation of ownership and control is complete. Unlike previous studies, we employ a measure of relative performance which compares a firm’s actual Tobin’s Q to the Q* of a hypothetical fully-efficient firm having the same inputs and characteristics as the original firm. We find that the Q of the average firm in our sample is around 10% lower than its Q*, equivalent to a $1340 million reduction in its potential market value. We investigate what causes firms to fail to reach their Q* and find that our firms are more efficient, the higher the CEO stockholdings and option holdings are, and the more sensitive CEO options are to firm risk. We also show that boards respond to inefficiency by subsequently strengthening incentives or replacing inefficient CEOs.