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This chapter is from the book

This chapter is from the book

Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences, 2nd EditionCorporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences, 2nd Edition

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This chapter is from the book

This chapter is from the book

Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences, 2nd EditionCorporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences, 2nd Edition

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Relationship between Corporate Governance and Firm Performance

According to a survey by McKinsey & Company, nearly 80 percent of institutional investors responded that they would pay a premium for a well-governed company. The size of the premium varied by market, ranging from 11 percent for a company in Canada to around 40 percent for a company in Morocco, Egypt, or Russia (see Figure 1.4).36

Figure 1.4

Figure 1.4 Indicated premiums for good corporate governance, by country.

Source: Paul Coombes and Mark Watson, “Global Investor Opinion Survey 2002: Key Findings” McKinsey & Company (2002).

These results imply that investors perceive well-governed companies to be better investments than poorly governed companies.37 However, the extent to which this is true is not entirely clear.

As we will see throughout this book, many studies link measures of corporate governance with firm operating and stock price performance. Perhaps the most widely cited study was done by Gompers, Ishii, and Metrick (2003).38 They found that companies that employ “shareholder-friendly” governance features significantly outperform companies that employ “shareholder unfriendly” governance features. This is an important research study, but as we will see in Chapter 13, “Corporate Governance Ratings,” these results are not definitive. Currently, neither professionals nor researchers have produced a reliable litmus test that measures overall governance quality using a simple common tool.

The purpose of this book is to provide a basis for constructive debate among executives, directors, investors, regulators, and other constituents that have an important stake in the success of corporations. This book focuses on corporate governance from an organizational instead of purely legal perspective, with an emphasis on exploring the relationships between control mechanisms and their impact on mitigating agency costs and improving shareholder and stakeholder outcomes.

Each chapter examines a specific component of corporate governance and summarizes what is known and what remains unknown about the topic. We have taken an agnostic approach, with no agenda other than to “get the story straight.” In each chapter, we provide an overview of the specific topic, a synthesis of the relevant research, and concrete examples that illustrate key points.39 Sometimes the evidence is inconclusive (see the following sidebar). We hope that the combination of materials will help you arrive at intelligent insights. In particular, we hope to benefit the individuals who participate in corporate governance processes so that they can make informed decisions that benefit the organizations they serve.

Interpreting Empirical Research

Oliver Williamson, winner of the 2009 Nobel Prize in Economics, observed the following:

“I have no doubt that the economics of governance is influential in significant measure because it does speak to real-world phenomena and invites empirical testing. . . . All feasible forms of organizations are flawed, and . . . we need to understand the trade-offs that are going on, the factors that are responsible for using one form of governance rather than another, and the strengths and weaknesses that are associated with each of them.”40

Still, the interpretation of empirical tests (academic or other) requires some understanding of their limitations:

  1. The results cited in empirical tests are typically average results generated from the statistical analysis of large samples of firms. Large samples enable a researcher to identify trends that are generally prevalent across companies. However, they do not tell us what we can expect to find at a specific company. Case or field studies can help answer firm-specific questions, but their results are difficult to generalize because they are based on only a handful of firms that may not be typical of the general population of firms.
  2. Empirical tests can identify associations or correlations between variables, but they do not generally demonstrate causality. This is a recurring problem in nonexperimental social science. If we observe a negative stock price return when a company adopts a governance change, it does not tell us that the change caused the stock price decline. It is possible that another (exogenous) factor might have been the cause. Ideally, we would control for this by observing what would have happened had another action been taken (the counterfactual outcome); however, this is impossible to observe. In corporate governance, we do not have the luxury of controlled samples. Still, competently generated empirical results are superior to guesswork or intuition.
  3. The performance metrics that governance researchers typically use fall into two broad categories: operating metrics and stock price metrics. Operating metrics (such as return on assets and operating cash flow) are somewhat backward looking but are generally considered to provide insight into value changes within the firm. Stock price metrics are typically based on abnormal or excess returns (the so-called alpha, calculated as observed stock price returns minus the expected returns, given the risk of the stock). Assuming reasonably efficient markets, excess returns provide a measure of change in economic value for shareholders. The researcher must determine which metric is better for evaluating the question at hand. Presumably, studies based on stock price returns and operating performance should provide similar results.
  4. Another metric that is commonly used in governance research is the market-to-book ratio (sometimes referred to as Tobin’s Q or simply Q). Q is based on the theory that a firm with superior performance will trade in the market at a valuation that is higher than the accounting value of its net assets. While this may be somewhat true, we view Q to be an ambiguous measure of firm performance and inferior to traditional operating metrics and excess stock price returns.41
  5. We sometimes refer to event studies. Event studies measure the stock market’s reaction to news or events. These studies have validity only to the extent that the reader believes that markets are at least partly efficient. Even if so, event studies cannot easily control for confounding events (such as other news released by the company during the measurement period). Moreover, event studies require the researcher to make important risk adjustments when computing excess stock returns. Although several risk adjustments have become “accepted,” their computation is complex, and it is difficult to know whether the researcher made them properly.

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