Incentivizing Effort and Informing Investment: The Dual Role of Stock Prices

Abstract

Stock prices reflect managerial performance and aggregate investor information about investment opportunities. We show that these dual roles are in tension: when prices are more informative about future opportunities, they may be less effective at incentivizing managerial effort. Firm value can decrease with price informativeness, but increase with ex-post inefficient investment rules and lower transparency. The relation among price informativeness, performance sensitivity and duration of managerial compensation, delegation, and firm value depends crucially on the importance of investment opportunities relative to managerial performance. Standard empirical measures of efficiency can be misleading because they ignore the dual role of prices.

Keywords: contracting, feedback effect, optimal compensation, price efficiency, transparency

JEL Classification: D8, G1