Efficiency of firm’s operations determines the optimal use of inputs that create cash flows, which in turn are affected by firm factors pertaining to the firm. Those firm factors include but are not limited to production characteristics (i.e., R&D and advertising), forecast characteristics (consensus forecast error and dispersion), and identity measures (book-to-market, BE/ME and size). This study will link the firm’s efficiency to these firm factors by benchmarking the actual value of the firm relative to its optimal value and studying the impact of the factors on their efficiency score. Our findings suggest that firm factors impact the level of firm efficiency, which has a direct effect on the ability of a firm to optimally use the inputs that create cash flows, implying that there is value for firms in setting a goal of operating at a high level of efficiency.
The efficiency of a firm’s operations determines the optimal use of inputs that create cash flows, which in turn are affected by the relating characteristics (firm factors) associated to the firm. These firm factors include, but are not limited to, production characteristics (R&D and advertising), forecast characteristics (consensus forecast error and dispersion), and identity measures (book-to-market and size). Research has shown that more efficient firms tend to have more stable levels of output compared to other firms within the same industry (Mills and Schumann, 1985). To the best of our knowledge, no study has yet investigated the full or combined effects of several of these factors on the efficiency of the firm.
This study will provide a nexus between a firm’s efficiency to the associating firm’s characteristics by benchmarking the actual value of the firm relative to its optimal value, and studying the impact of the factors on the calculated benchmark efficiency score. The efficiency score is obtained by using the Stochastic Frontier Method (SFM), first introduced by Aigner, Lovell, and Schmidt, 1977. Although SFM is widely used to measure firm efficiency in production economics, its use is not as widespread in finance. However, the benefits of using the SFM are twofold: (1) it provides a clear picture of the true market value of the firm relative to its optimally scientifically determined value; and (2) it provides statistics against which other variables’ effects can be measured. In other words, this method dominates traditional techniques by developing robust and reliable measures of firm performance.
The importance of firm efficiency cannot be overstated. Demsetz (1973, 1974) finds that more efficient firms tend to have greater market shares and larger profits as a result of their low production costs. Therefore, these firms are better able to withstand economic demand shocks as well as outside competition. Margaritis and Psillaki (2007) surmise that more efficient firms have an incentive to limit their risk exposure and as a result they choose lower debt to equity ratios relative to less efficient firms. As such, the franchise value enjoyed by the higher level of firm efficiency is protected. Nguyen and Swanson (2007) hypothesize that the level of firm efficiency should affect the riskiness of a firm’s cash flows and cash flows should in turn affect firm equity returns. Specifically, the authors find that the level of firm efficiency is very significant in explaining average stock returns in cross-sectional regressions. Thus, they conclude that the level of firm efficiency has a significant impact on the level of stock returns and should be incorporated into asset pricing models.
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Market value, intangibles, and security analysts: a stochastic frontier analysis
