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Valuation Implications of Corporate Governance


“I believe that nothing can be greater than a business, however small it may be, that is governed by conscience; and that nothing can be meaner or pettier than a business, however, governed without honesty and without brotherhood.”

William Hesketh Lever

The relative quality, strength and reliability of a company’s corporate governance system have direct and profound implications for investor’s assessments of investments and their valuations. As we have seen in the massive corporate collapses in recent years, most or all of an investor’s capital can be lost suddenly if a company fails to establish an effective corporate governance system with the appropriate checks and balances.

Raymond & TCS were in news recently on issues relating to their corporate governance & their market prices were hit. As Adam Smith aptly put in The Wealth of Nations (1776) –“Like the stewards of a rich man, they (managers) are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company”, weak corporate governance systems pose a set of risks to the value of investments in the company:
1.  Accounting Risk- The risk that the company’s financial statement recognition and related disclosures, upon which investors base their financial decisions, are incomplete, misleading, or materially misstated. In 2009, Ramalinga Raju, the Chairman of Satyam confessed that he had manipulated accounts by USD 1.47 billion. The stock eroded investors’ wealth by almost INR 525 per share immediately.

2.      Asset Risk – The risk that the firm’s assets, which belong to investors, will be misappropriated by managers or directors, in the form of excessive compensation or other perquisites. The recent controversy of Infosys’s CEO Vishal Sikka’s Rs. 73 crore salary package is an instance for asset risk concerns of corporate governance failure. The board members have been raised objections against their support for this above-average managerial compensation.

3.      Liability Risk – The risk that the management will enter into excessive obligations, committed to on behalf of shareholders, which effectively de
stroy the value of shareholders’ equity; these frequently take the form of off-balance sheet obligations.

4.      Strategic Policy Risk – The risk that managers may enter into transactions, such as mergers and acquisitions, or incur other business risks that may not be in the best long-term interest of shareholders, but which may result in large payoffs for management or directors.

A report of OECD finds that, while risk-taking is a fundamental driving force in business and entrepreneurship, the cost of risk management failures is still often misunderstood, both externally and internally, including the cost in terms of management time needed to rectify the situation. Corporate governance should therefore ensure that risks are understood, managed, and, when appropriate, communicated.

Not surprisingly, a growing body of evidence indicates that companies with sound corporate governance systems show higher profitability and investment performance measures, including returns, relative to those assessed to have weaker structures. For example, a joint study of Institutional Shareholder Services (ISS) and Georgia State University found that the best-governed companies, as measured by the ISS Corporate Governance Quotient, generated returns on investment and equity over the period  under study that were 18.7% and 23.8%, respectively, better than those of companies with poor governance. Similarly, a study of US markets, conducted by researchers at Harvard Universityand the University of Pennsylvania, found that portfolios of companies with strong shareholder-rights protections outperformed portfolios of companies with weaker protections by 8.5% per year. A study of European firms found annual mean return differences of 3%.

This phenomenon is not limited to developed markets. Even before the collapse of Enron, a Malaysia-based analystfound that investors in emerging markets overwhelmingly preferred companies with good governance. Of the 100 largest emerging markets companies his firm followed, those with the best governance, based on management discipline, transparency, independence, accountability, responsibility, fairness and social responsibility, generated three year US dollar returns of 267%, compared with average returns of 127%. The disparity in five-year returns was even greater, at 930% versus an average of 388%.

The conclusion from these and other studies is that good corporate governance leads to better results, both for companies and for investors. Therefore, investors and analysts should carefully evaluate the corporate governance structures of companies they are considering as investments and should continue to monitor the systems once the investments are made.

An Analyst’s Checklist

It is clearly established in the above paragraphs that risk management framework in conjunction with the corporate governance mechanism of the company under valuation consideration needs a definitive attention. While the challenge is in measuring the amount of risk exposure and there exists no sacrosanct approach for the same, it cannot be denied that the valuation report quality and purposiveness is enhanced when a simple qualitative discussion on the risk management and corporate governance related issues are discussed. These should be thrown due attention such that the user of the report is allowed to take a better-informed decision.
Let us discuss few qualitative aspects that shed more light on a corporation’s status in terms of its preparedness towards external and internal risk matters. These can be taken as checklist items.

          Has the corporation adopted corporate governance standards suggested by globally renowned organisations?
For example, Infosys in its annual report claims have substantially comply with Euroshareholders Corporate Governance Guidelines 2000, the recommendations of the Conference Board Commission on Public Trusts and Private Enterprises in the US, United Nations Global Compact (UNGC)and the Organisation for Economic Co-operation and Development (OECD)principles.

          What is the company’s risk management framework? Is it meaningfully and all-inclusively developed? It may be useful to critically evaluate the risk management framework the company has adopted. Based on the industry the company is operating and various other particular variables affect the specific areas of operations where the company is exposed to risk. In addition, almost all the corporations would generally have Committees for Risk Management and Internal Quality Assurance. But, these may just not be enough for the analyst to conclude the risk management process is sufficiently in place. The analyst may have go through in detail about the objectives, functioning and achievements of these committees. These details may be difficult to obtain as an external analyst. The company’s Management Discussion and Analysis section can reveal some details regarding the risk management framework and the responsibility centres towards the same.

For example, Hindustan Unilever Limited’s risk management framework is based on three pillars: Business Risk Assessment, Operational Controls Assessment and Policy Compliance Processes. And, HUL has set up Risk Management Committee with an objective to monitor risks and their mitigating actions. The committee also discusses the risks with the Audit Committee. During the year 2015-16 some of the risks identified by the committee were related to Competitive Intensity and Cost Volatility. The company claims to conduct regular statutory and internal audits on its Internal Control Systems.

          What are the internal governance mechanisms the company has employed? Analyst can get an overview of company’s governance mechanism by attempting to understand, from information sourced from different sources (mosaic theory) regarding the legal authority and power for board of directors to hire, fire and compensate top management, raise capital, approve M&A plans, approve accounts, declare dividends and maintain general surveillance over the corporate affairs. It may also be helpful to understand the structure and diligence of the internal systems of performance monitoring and responsibility accounting. Analyst may also need to analyse the extent to which the management compensation is linked to shareholder returns.

          What are the external governance mechanisms the company has in place? Is the investor communication given importance duly by publishing financial statements periodically, statutorily getting the audited the statements by an independent auditor? What are the hostile takeover defences administered as a policy matter to manage the market for corporate control?

          Earnings Quality Vs Reporting Quality? While most of the valuation models use the earnings reported by management released financial statements, as a pre-requisite, the analyst need to satisfy himself as to the reporting quality(defined as the error-free, true & fair representation of firm’s financial affairs for the period) being of high standard. The entire valuation exercise will be useless if the inputs for the modelling are of low quality. Analyst may want to probe as to what systems are in place to curb the potential window dressing. Warren Buffet describes the reporting quality and investor communication being affected by diverging goals of management from that of shareholders  in his famous letter to shareholders of Berkshire Hathaway (1989)as ‘institutional imperative’. Quoting him:
My most surprising discovery: the overwhelming importance in business of an unseen force that we might call the ‘institutional imperative’. In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational decisions. But, I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play. (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction, (2) Just as work expands to fill available time, corporate projects or acquisitions will materialise to soak up available funds, (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops, and (4) The behaviour of peer companies, whether they are expanding, acquiring, setting executive compensation, or whatever, will be mindlessly imitated. Institutional dynamics, not venality or stupidity, set business on these courses, which are too often misguided.”

In SUMMARY, we can say:     
  1. A good Corporate Governance is inevitable for good valuation and analysts cannot ignore the same
  2. It is difficult quantify the effectiveness of a corporate’s governance system and analysts need to apply mosaic theory to gather perspectives
  3. It is the analyst’s efficiency in gathering information and interpreting the implications on the long-term value of the company that determines the validity and reliability of the valuation model.