Firm Value and Managerial Incentives: A Stochastic Frontier Approach*

We provide a direct estimate of the magnitude of agency costs in publicly held corporations. We compute an explicit performance benchmark that compares a firm's actual Tobin's Q to the Q* of a hypothetical value-maximizing firm having the same inputs and characteristics as the original firm. The Q of the average sample firm is around 16% below its Q*, equivalent to a 1, 432 million reduction in its potential market value. We relate the shortfall to the incentives provided CEOs. Boards appear to grant CEOs too few shares and too many options that are insufficiently sensitive to firm risk.