Tobin’s Q Does Not Measure Performance: Theory, Empirics, and Alternative Measures

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 5, 2010 at 9:21 am
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Editor’s Note: This paper comes to us from Philip Dybvig, Professor of Banking and Finance at Washington University in Saint Louis, and Mitch Warachka, Associate Professor of Finance at Singapore Management University.

In the paper Tobin’s Q Does Not Measure Performance: Theory, Empirics, and Alternative Measures, which was recently made publicly available on SSRN, we provide a simple theoretical framework to demonstrate that underinvestment by entrenched managers confounds the relationship between Tobin’s Q and corporate governance. In particular, stronger corporate governance can decrease Tobin’s Q as well as return on assets. Overall, the relationship between corporate governance and Tobin’s Q is ambiguous. This ambiguity arises from managerial decisions regarding scale and cost discipline having offsetting effects on Tobin’s Q.

Our framework then develops two unambiguous measures of operating efficiency. The first measure uses revenue to assess managerial decisions regarding their firm’s level of output, while the second measure uses costs to assess the cost discipline of management. These operating efficiency measures are derived from the maximization of market value net of invested capital.

Empirically, the corporate governance index in Gompers, Ishii, and Metrick (2003) and institutional ownership capture cross-sectional differences in operating efficiency. In particular, firms associated with stronger governance exhibit better operating efficiency. However, better operating efficiency lowers Tobin’s Q, a finding that is consistent with underinvestment’s ability to inflate Tobin’s Q.

A number of issues remain for future research. Our framework can be extended by introducing leverage as entrenched managers may play it safe by using a suboptimal amount of debt. In addition, future empirical research can examine whether mergers improve or reduce operating efficiency.

The full paper is available for download here.


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