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

Abstract

Empirical studies in the corporate governance literature often use Tobin’s Q as a proxy for firm performance. However, our theoretical framework illustrates that the relationship between firm performance and Tobin’s Q is confounded by endogeneity. In particular, inefficiency due to underinvestment lowers firm performance but increases Tobin’s Q. We then use our framework to derive two operating efficiency measures that unambiguously capture firm performance. The first measure assesses managerial decisions regarding scale and the second measure assesses managerial cost discipline. These proxies for firm performance are justified by the ideal of maximizing firm value net of invested capital. Consistent with the importance of scale decisions, our empirical implementation indicates that underinvestment inflates Tobin’s Q. Consequently, a high Tobin’s Q is not evidence of good firm performance. Furthermore, the inverse relationship between the corporate governance index of Gompers, Ishii, and Metrick (2003) and firm performance reverses after replacing Tobin’s Q with our scale-based measure of operating efficiency.