CG & Valuation Flashcards
How should CG influence Valuation?
− Better corporate governance should be associated with lower agency costs, i.e., fewer investment distortions,
less perk consumption and shirking etc.
− As a consequence, one can expect less capital and free cash flow are diverted by self-serving managers, i.e.,
FCF to equity should be higher
− Due to disclosure requirements etc., investors should realize this and, hence, be willing to pay more for well-governed companies leading to higher asset prices
− Numerator in the Tobin’s q formula should react to news about corporate governance (while the denominator
should remain unchanged) leading to changes in Q
→ Well-governed firms should be associated with higher values of Tobin’s Q
What are many studies only able to show?
correlations between variables (e.g., y = firm value and x = governance
quality)
What do correlations suggest?
that it is likely that there is a positive relation between two variables, but they do not (per
se) provide causal evidence (i.e., x determines y)
What are govenrnance studies in academia and, particularly, in practice, plagued by?
numerous statistical concerns
which make drawing valid inferences very difficult
How to Measure Corporate Governance?
− Instead of looking at a single control mechanism, broad corporate governance indexes are constructed
What is Construction? (from how to measure Corporate Governance)
A value of one is assigned to each governance attribute that a firm has in place, and zero
otherwise
On what principle are the codes of many countries in Europe based on?
comply-or-explain principle
Explain the comply-or-explain principle
− Acknowledges that “one size may not fit all” and that
flexibility is required
− Yet, if a recommendation is important but many firms do not
comply with it, it may become mandatory
On what does the comply-or-explain principle rely on and why?
Relies on the functioning of self-regulation, since
a) those that should be regulated are members of the commission
b) authorizes executive and supervisory board to diverge
Through what is the comply-or-explain principle enforced?
through market pressure and valuation
Explain Drobetz et al. (2004)
Construct a German corporate governance rating as a proxy for firm-level governance:
− To qualify for an inclusion into the rating, each practice and attitude
i. must refer to a governance element that is not (yet) legally required
ii. needs to be considered as international market practice from an investor’s perspective
What are the relations between corporate governance and firm value?
− Document a strong positive relation between the quality of
firm-level corporate governance and firm value
− Valuation measures: (i) Tobin’s Q and the (ii) market-tobook ratio
Explain Gompers et al. (2003)
- Proxy fights
Construct a “Governance Index”: Proxy for the balance of power between managers and shareholders
− Proxy fights and hostile takeovers were rare, and investor activism was in its infancy
− The rise of the junk bond market in the 1980s disturbed this equilibrium by enabling hostile-takeover offers
many states passed anti-takeover laws giving firms defenses against hostile bids:
By 1990 there was considerable variation across firms in the strength of shareholder rights
Explain Gompers et al. (2003)
- the index construction
The index construction is straightforward:
− For every firm one point is added for every provision that reduces shareholder rights
− Governance Index (“G”) is just the sum of points for the existence of each provision
Provisions can be divided into 5 main groups
What are the 5 main groups that Provisions can be divided into?
− Tactics for delaying hostile bidders (Delay) - Classified Board
− Voting rights (Voting) - Unequal Voting
− Director/officer protection (Protection) - Golden Parachute
− Other takeover defenses (Other) - Posion Pill
− State laws (State) - Fair Price Law
Which two extreme portfolios pays the Gompers et al (2003)
“Dictatorship Portfolio”
“Democracy Portfolio”
Explain the “Dictatorship Portfolio”
− Firms in the highest decile of the index
− having the “highest management power”
− or the “weakest shareholder rights”
Explain the “Democracy Portfolio”
− Firms in the lowest decile of the index
− described as having the “lowest management power”
− or the “strongest shareholder rights”
Explain the Gompers et al. (2003) investment strategy
Gompers et al. (2003) build portfolios of well (Democracies) and poorly governed firms (Dictatorships) and calculate monthly portfolio returns over their sample period
An investment strategy that
− bought firms in the lowest decile of the index (strongest rights)
− sold firms in the highest decile of the index (weakest rights)
would have earned abnormal returns of 8.5 percent per year during the sample period
What are the outcomes of Gompers et al. (2003) investment strategy?
− Market participants in 1990s were not able to forecast accurately the significance of governance for the
expected future performance of firms
− Hence, prices in the 1990s had not yet precisely priced the expected effects of the differences between wellgoverned and poorly governed firms on future profitability
→ Trading on the basis of such differences is profitable
Explain Bebchuk et al. (2009)
Investigate the relative importance of the twenty-four provisions followed by the Investor Responsibility Research
Center (IRRC) and included in the GIM governance index
→Which provisions, among the many provisions that firms have, are the ones that play a key role in the link
between corporate governance and firm value?
What are the provisions garnering significant shareholder opposition (Bebchuk et al. (2009)?
− Voting decisions on shareholders‘ resolutions
− Which of the 24 IRRC provisions were opposed by a nontrivial number of resolutions that often passed?
→4 types of precatory resolutions – targeting 6 IRRC provisions – stood out
What are the four types of precatory resolutions, and six IRRC provisions are targeted (Bebchuk et al. 2009)?
- Resolutions against classified boards, which passed in 91% of the votes on them during 2003–2004
- Resolutions against poison pills, which passed in 72% of the votes on them during 2003–2004
- Resolutions against golden parachutes, which passed in 62% of the votes on them during 2003–2004
- Resolutions against supermajority provisions, which simultaneously targeted, supermajority merger
requirements, limits on charter amendments
What are the main findings (Bebchuk et al. 2009)?
The 6 provisions included in the E index fully drive the findings documented by prior research that the IRRC
provisions in the aggregate are correlated with Tobin’s Q
Bebchuk et al. (2009) contribute to understanding GIM’s results concerning the association between governance
& abnormal returns
→Bebchuk et al (2013) show that there is a disappearing association between governance and returns during
the period of 2000–2008
Explain Bebchuk et al. (2013)
In 1990, investors might not yet have had sufficient experience to be able to forecast the expected difference in
performance between well-governed and poorly governed firms
→Market prices in the 1990s had not yet precisely priced the expected effects of the differences
Over time, a sufficient number of market participants have learned to appreciate the significance of these
differences
→Trading on the basis of these governance indices should not be expected to yield abnormal profits
Through what were proxies identified for the attention to governance (Bebchuk et al. 2013)?
− the media
− institutional investors
− academic researchers
And finally construct an aggregate
What’s the empirical finding (Bebchuk et al. 2013)?
(Long-run) Abnormal returns decreased to zero as the attention paid to corporate governance heightened
What will good governance cease to be associated with at the end of the learning period and why? (Bebchuk et al 2013)
abnormal returns after the end of the learning period simply because the improved performance associated with good governance will become factored into market prices
What is better governance positively related to (according to Bhagat & Bolton 2008)?
contemporaneous and
future operating performance, but not correlated with stock price performance
Conclusions
− Corporate Governance quality difficult to condense into single number
− Causal and significant relationship between governance and firm value
− Investors only gradually learned about the importance of governance
− In efficient markets, this implies that investors cannot earn positive abnormal returns by holding portfolios of
well-governed firms
