Does Corporate Governance really matter in a Company’s Valuation?

You hold stocks of a well known multinational company and one day there’s a sudden crash in its prices on the stock exchange. There’s a rumor of a big accounting fraud going on in the company for over 5 yrs – well hidden and covered by a lot of people you would never expect to be involved in something like this! Does this ring a bell? Wake up – its corporate governance calling.

What is Corporate Governance?

Corporate Governance is defined by various experts in different ways. In a nutshell, it refers to the relationship that exists between the stakeholders of the company and the manner in which the company is controlled and decisions are taken. The stakeholders are both internal and external – board of directors, executives, employees, shareholders, debt-holders, trade creditors, suppliers, customers and the community.  Good corporate governance should help achieve the goals of the company and be beneficial for all the stakeholders. It leads to enhanced accountability and transparency in all aspects of conducting business.

Why is Corporate Governance Important?

Your primary objective as a profit-seeking organization is to maximize the shareholder’s wealth.  And corporate governance, both directly and indirectly impacts this to a large extent. A McKinsey research suggests that “institutional investors will pay as much as 28 percent more for the shares of well-governed companies in emerging markets”.

But how does this translate into higher valuation for your company? You know that your valuation is impacted by cash flows, cost of capital and market sentiments. So let’s analyze the impact of corporate governance on these-

• Allows early detection of any fraudulent activities taking place in your organization: When your corporate governance systems and processes are efficiently designed and executed, any fraudulent activity can be detected rather quickly before it turns big. This directly leads to protection of your company’s resources and assets.
• Directly impacts the topline: A growing section of consumers prefer to buy products/services of companies with good corporate governance policies as it assures them of a better customer service and redress mechanism too. This will directly impact your topline.
• Helps reduce the expenses and losses due to Lawsuits: Good corporate governance policies will reduce instances of customer dissatisfaction, poor product quality, loan defaults, regulatory incompliance and other causes of litigation against your company. It will reduce both the cost of legal cases and the penalties associated with them.
• Reduces the cost of borrowing: Lenders will perceive you as less risky, due to your transparent ways of working and this will improve your market reputation and ultimately bring down your borrowing costs.
• It instills confidence in the market that your company has well-defined systems, principles, processes and checks in place to manage all functions and eliminate conflict of interests. Investors prefer companies with good corporate governance practices and a strong and efficient management.
• Investor Psychology: Investors will perceive your company’s stock to be a good and safe investment if it has a proper corporate governance framework in place.
• Fund mandates: Many modern day funds have mandates to invest in stocks and bonds of companies which have a minimum corporate governance standard or score. This will directly lead to greater demand for your firm’s securities.
• Global investors investing in emerging markets, look to reduce risks of management malpractices associated with small emerging market companies. So if you are a player in an emerging market, with an established track record of good corporate governance policies, overseas investors will prefer you over others.

So what needs to be done?

So how can you increase your company’s valuation? You need to setup a strong and effective corporate governance framework, which should take care of three important aspects:

• Accountability to shareholders and shareholders equality – Your company’s ownership structure should be transparent without complex cross-holdings. The Board of Directors should be of optimum size (neither too small like 2-3, nor too large like 20-25), and should be made accountable to the shareholders. Moreover, all the shares of the company should have equal and commensurate voting rights.
• Independence: The ownership of your company should be spread-out and you should ensure independent audits by establishing strong internal controls. Moreover, majority of the Board of Directors should be independent, i.e. should not be in any way connected with the day to day affairs of the company.
• Disclosure and transparency: You should ensure complete and timely disclosure of all important information to your shareholders. Moreover, you should follow internationally accepted accounting standards while preparing your financial statements.

You should not forget that in today’s times, people are wary of another Enron turning up on them. Hence, corporate governance can provide the halo to differentiate your brand image. Imbibing a culture of commitment towards strong corporate governance will definitely help increase your company’s valuation.

– Research Optimus