A business that operates in such a way as to maximize its owners’ wealth allocates its own resources efficiently, which results in an efficient allocation of resources for society as a whole. Owners, employees, customers, and anyone else who has a stake in the business enterprise are all better off when its managers make decisions that maximize the value of the firm. Therefore, evaluating a firm’s management on the basis of whether it maximizes the owners’ wealth is a reasonable approach.

Evaluating a firm’s performance seems to be a rather straightforward issue, but it is not. By focusing on the maximization of a stock’s price, one might conclude that the higher the stock’s price, the better the performance of the firm’s management. But should management be penalized if the market declines? Should management be praised simply because the economy has recovered? Should management be rewarded for taking on excessive risks?

Evaluating a firm’s performance is much more challenging than looking at its stock price, and evaluating the performance of specific managers is even more challenging. Regulators and shareholder activists have long complained about the way firms pay executives, especially when pay is not linked to performance. Even when executive pay is linked to performance, the issue of how to measure performance remains. If pay is linked to accounting earnings, the possibility exists that these accounting earnings can be manipulated to produce high pay for the executives ...

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