A Measure of Total Firm Performance: New Insights for the Corporate Objective

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.

Keywords: Corporate Objectif; Utility Manimization; Firm Performance; Managerial Ownership; Agency Theory

JEL Classification: L1, L2, G32