Stock Price, Earnings and Book Value in Managerial Performance Measures

This paper develops a multiperiod principal-agent model in which a manager must be given incentives to undertake investments and to exert personally costly effort. Investments are "soft" (e.g., intangible assets) and therefore entail measurement errors for the accounting system as it seeks to separate investments from operating expenditures. This separation is of no concern to the stock market which draws on its own information about future cash flows resulting from current investments. The firm's stock price, however, reflects all value relevant information, parts of which are not incentive relevant. Optimal incentive provisions must combine "forward looking" market information with "backward looking" accounting information. Under certain conditions, optimal performance measures can be expressed as a weighted average of economic value added (residual income) and market value added.