Promoters and Managers Must Develop Effective Corporate Governance for Increased Market Valuation

Effective corporate governance (CG) is that secret sauce in an organisation’s journey that holds it together. When the principles of CG are at play, it often does not matter to external stakeholders but when it fails, the results are catastrophic, as we have seen time and again in some of the most spectacular falls from the grace. It can be argued that cases like Enron and Worldcom in the U.S. and Satyam, DHFL, Geetanjali and Nirav Modi in India are exceptions and representative of extreme cases of promoter / manager greed and willful misconduct. While this may be true, the fact remains that poor CG impedes value creation.

While it is certain that willful neglect will be disastrous for any company, how does the quality of a company’s CG impact performance? This article explains how CG plays a significant role in determining the valuation of a company. This topic is supported by a vast amount of research, some is presented here.

At its very core, the objective of effective CG is to protect the interest of shareholders and providers of capital. In the recent times, the objectives have evolved to also cover the interests and rights of external stakeholders who deal with the organization on a good faith basis. Accordingly, the definition of CG has also evolved to ensure that businesses are directed and controlled in a manner to ensure responsible decision-making that aims to protect the interests of external stakeholders and provides valuable resources to the organisations.

Effective and well-functioning CG is a powerful signaling strategy which assures the shareholders of effective monitoring and control which in turn will result in the shareholders and stakeholders providing the firm with access to valuable resources which it needs for its growth resulting in superior performance.

This is the second of a three-part series on the importance of effective Corporate Governance (“CG”) for any organization – public or private. In this edition we discuss the correlation between CG and a company’s valuation by comparing the G scores of Democracy CG companies vs. Dictatorship CG companies.

(For Part 1: Scaling up Corporate Governance is a Must for a Successful Capital Raise, click here.) 

High CG Company Stocks Outperform Low CG Stock by Nine Percent Per Year Over a Nine-Year Period

Gomers and Ishii (Harvard University) and Metrick (University of Pennsylvania) in February 2003 presented a paper in the Quarterly Journal of Economics entitled “Corporate Governance and Equity”. This paper presented their research conducted over nine years from 1990 to 1999 on 1,500 large firms. The paper ranked these firms on a governance index (G) after analyzing these firms on 24 governance-related parameters. The G score represented shareholder right and the firms that ranked high on the G score (strong shareholder rights) consistently outperformed the low G score firms (weak shareholder rights) on overall corporate performance.

The paper ranked the firms on the G score and the firms that were high on the governance index and provided highest rights to the shareholders were called the Democracy portfolio and the ones that provided weakest shareholder rights (low G score) were called the Dictatorship Portfolio.

The research found that the democracy portfolio outperformed the dictatorship portfolio by 8.5 percent per year. A $1.00 investment in dictatorship portfolio would have grown to $3.39 over a period of nine years which was a 14 percent annualized return. In contrast a $1 investment in democracy portfolio increased to $7.07 over the same period yielding a 23 percent annualized return, a difference of 9 percent.

The democracy portfolio also had a better firm valuation than the dictator portfolio. This finding was also consistent with vast study conducted elsewhere that has found a positive correlation between CG and firm value. Further, the paper also presented evidence that in general more democratic firms have better operating performance.

Does the Government Index Still Hold Today?

In India, careful scrutiny of the publicly-listed banking stocks will reveal that those banks that have robust CG on place have consistently outperformed peers by a huge margin. Such democracy stocks outperform their dictatorship peers in multiple metrics[1] such as ROCE, ROE, EBITDA, CMV/BV and have delivered the highest CAGR over a the last five years.

While it is well-established that CG has a significant positive impact on the firm valuation, it is difficult to determine exact linkages. Further, CG requirements differ from industry to industry, whereby some industries require  more governance than others. Also, the need for governance may vary depending on the age of the firms. Younger firms need less governance than mature firms as the boards of younger firms are more focused on the value creation function. On the contrary, in mature firms, where there is a separation of ownership and management, the board is more focused on value protection function and hence lays significant emphasis on CG as a value protection lever. Irrespective, CG is an area that should be managed proactively and efficiently in order to maximize firm value.

How A&M Can Help

Irrespective of the industry or the age of the firm, promoters and management should focus on implementing strong CG that works effectively. Some key provisions that are necessary and required by regulators are:

1. Board Independence
2. Audit Committee Activity
3. Board Structure & Composition
4. Financial & Internal Controls
5. Code of Conduct
6. Policies & Procedures

Determining the adequacy of the CG provisions can be a daunting task, as these provisions should be customized to the business and industry needs. Further, such measures should be aligned to the business needs. Unnecessary bravado can be counter-productive, as it can stifle decision-making and hamper business agility.

A&M professionals can assess the current maturity level of a firm’s CG framework based on the specific needs of the business and recommend a desired state of maturity and an implementation plan to successfully get there.