Abstract
Because heterogenous and unknown shareholder utility functions make it difficult to define a corporate objective common to all shareholders based on utility, the traditional theory of the firm concentrates on wealth maximization as the main measure of performance. Using the concept of ranked marginal utility, we develop a multi-dimensional measure of firm performance (TPM) that reflects the preferences of all risk averse shareholders towards all aspects of risk. We verify empirically that this is, in fact, the case for the first four moments of a large sample of US stocks over the period 2002–2010. Then, using the manager/shareholder agency conflict as the analytical framework, we show that TPM is a reliable, multi-dimensional performance measure and that one dimensional performance measures, such as mean returns, volatility or Tobin’s Q can lead to erroneous inference. By including shareholder preferences towards risk in the measure of firm performance as the corporate objective, we bring together the corporate finance literature and the literature on portfolio investment theory and practice.
Highlights
The literatures on corporate finance and modern investment theory are both based on the principle of utility maximization, heterogenous and unknown shareholder utility functions make it difficult to define a firm goal common to all shareholders based on maximum utility
In this paper we propose a methodology to address the problem of heterogenous and unknown shareholder utility functions that make it difficult to define a corporate objective common to all shareholders based on maximum utility
Using the concept of ranked marginal utility, we develop a multi-dimensional measure of firm performance that reflects the preferences of all risk averse shareholders towards all aspects of risk
Summary
The cornerstone concept of performance and the “corporate objective” in the traditional theory of the firm is shareholder wealth maximization. For example, the corporate agency conflict literature, sparked by the seminal paper of Jensen and Meckling (1976), has focused for the most part on some form of wealth creation, such as stock returns or Tobin’s Q, and has ignored how stock returns or the changes in Tobin’s Q are distributed. Modern investment theory, has shown the importance of the distribution of wealth outcomes as well as the level of wealth itself. the literatures on corporate finance and modern investment theory are both based on the principle of utility maximization (see, for example, Ross 1973; Jensen and Meckling 1976), heterogenous and unknown shareholder utility functions make it difficult to define a firm goal common to all shareholders based on maximum utility. By including shareholder preferences towards risk in the measure of firm performance, we bring together the corporate finance literature and the literature on portfolio investment theory and practice. When we examine the relationship between MO and other measures of firm performance, such as returns, return volatility, skewness and kurtosis, the effects on whether or not they enhance the risk averse shareholder’s utility are often conflicting. This is evidence that the individual moments provide only a partial and potentially misleading picture of overall stock performance that is difficult to interpret when standing alone.
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