The Relationship between Accounting and Market Measures of Firm Financial Performance: How Strong Is It?

The construct of firm performance is of central importance to management research because explaining variation in performance is an enduring theme in the study of organizations (e.g., Hoopes et al., 2003). Although firm performance has been recently proposed as a multidimensional construct that consists of many different aspects such as operational effectiveness, corporate reputation, and organizational survival (Richard et al., 2009), one of the most extensively studied areas is its financial component, the fulfillment of the economic goals of the firm (Barney, 2002; Venkatraman and Ramanujam, 1986). To assess the financial aspect of firm performance (i.e., financial performance), organizational researchers generally use either accounting-based measures of profitability such as return on assets (ROA), return on sales (ROS), and return on equity (ROE), or stock market-based measures such as Tobin's Q and market return (Combs et al., 2005; Hoskisson et al., 1999; Hult et al., 2008). Although both accounting-based and market-based measures are widely accepted as valid indicators of firm financial performance, there is an ongoing debate about their relationship in management research, especially regarding how closely they are related (Chakravarthy, 1986; Combs et al., 2005; Keats, 1988; Murphy et al., 1996; Richard et al., 2009; Rowe and Morrow, 1999). Theoretically, researchers generally conceptualize accounting measures as reflections of past or short-term financial performance, and market measures as reflections of future or long-term financial performance (Hoskisson et al., 1994; Keats and Hitt, 1988). However, there is no consensus about the relationship between past/short-term performance and future/long-term performance. In an oft-cited article that conceptualizes both accounting and market measures as indicators of the financial aspect of firm performance, Venkatraman and Ramanujam (1986) suggest that these measures can be unrelated because of the conflicts between achieving short-term and long-term economic goals. Among those who expect accounting and market measures to be related, there is a debate about whether their relationship is sufficiently high so that they can be treated as equivalent, interchangeable measures of firm financial performance (Combs et al., 2005; Richard et al., 2009). Empirical findings are mixed about the relationship between accounting and market measures of financial performance. While some studies report a positive relationship (Hoskisson et al., 1994; McGuire and Matta, 2003), others report a negative relationship (Keats and Hitt, 1988; Nelson, 2003) or no relationship at all (Chakravarthy, 1986; Hillman, 2005). In the few studies using factor analysis and structural equation methods, the findings are also mixed. Rowe and Morrow (1999) report that the first-order factors of accounting profitability and market performance are significantly correlated with each other and load significantly on a second-order factor. In contrast, Keats (1988) and Combs et al. (2005) find the empirical overlap between accounting profitability and market performance to be relatively small and that they do not converge into a higher order factor. This ongoing debate about the relationship between accounting and market measures has important implications for organizational research because it concerns whether firm financial performance can be treated as a single unidimensional construct (Combs et al., 2005; Keats, 1988; Richard et al., 2009; Rowe and Morrow, 1999) (1). If accounting and market measures are highly correlated, that is, they demonstrate sufficient convergent validity (Nunnally and Berstein, 1996; Schwab, 1999), it suggests that these measures can be treated as equivalent, interchangeable indicators of firm financial performance, a necessary condition to be considered a single unidimensional construct. In this situation, theories of firm financial performance that find support in accounting measures should also find support in market measures, and vice versa. …