An Integrated Framework of Corporate Governance and Firm Valuation

Department of Finance, Wirtschaftswissenschaftliches Zentrum (WWZ), University of Basel, Petersgraben 51, 4003 Basel, Switzerland e-mail: stefan.beiner@unibas.ch, wolfgang.drobetz@unibas.ch, markus-max.schmid@unibas.ch, heinz.zimmermann@unibas.ch
From a theoretical point of view, agency problems may affect the value of firms through the expected cash flows accruing to investors and/or the cost of capital. First, agency problems make investors pessimistic about future cash flows. La Porta et al. (2002) argue that investors bid up stock prices, because ‘with better legal protection, more of the firm’s profits would come back to them as interest or dividends as opposed to being expropriated by the entrepreneur who controls the firm’.1 Second, good corporate governance decreases the cost of capital to the extent that it reduces shareholders’ monitoring and auditing costs (e.g., Lombardo and Pagano, 2002). Recent empirical studies support this proposition. La Porta et al. (2002) document higher valuation of firms in countries with better protection of minority shareholders. Durnev and Kim (2005) and Klapper and Love (2004) use data on firm-level corporate governance rankings and find that companies with better governance and better disclosure standards exhibit higher Tobin’s Qs.2 Drobetz et al. (2004) construct a broad corporate governance rating related to the German Corporate Governance Code and document a positive relationship between governance practices and firm valuation for German public firms. Similarly, Bauer et al. (2004) use Deminor Corporate Governance Ratings for companies included in the FTSE Eurotop 300 index and find that higher ratings lead to higher common stock returns and enhance firm value. Gompers et al. (2003) construct a governance index based on takeover defences for a sample of US firms. They report that firms with better governance receive higher market valuations and have better operating performance and lower capital expenditures. However, most studies do not appropriately address the issue of endogeneity, i.e., the results can only be interpreted as partial correlations without indication of causality. An exception is the study by Black et al. (2003), who also find a positive relation between their governance index and Tobin’s Q for a sample of Korean companies. They apply a three-stage least squares (3SLS) approach and show that a 10-point increase (out of 100) in the governance index leads to a 19.4% increase in Tobin’s Q.
Keywords: corporate governance; principal-agent problems; ownership structure; firm valuation; endogeneity. JEL classification: G12, G32, G34, G38
We thank Yakov Amihud, Manuel Berger, Wolfgang Bessler, John Doukas (the editor), Filippo Ippolito, Colin Mayer, Tarun Ramadorai, Regina Riphan, Frank Schmid, Nico Waldmeier, Gabrielle Wanzenried, David Yermack, and an anonymous referee as well as participants in seminars at the University of Oxford, the University of St. Gallen, and the University of Frankfurt for helpful comments. We also thank Max Schmid for his large contribution to the collection of compensation and shareholding data from the annual reports. Financial support from the National Center of Competence in Research ‘Financial Valuation and Risk Management’ (NCCR FINRISK) is gratefully acknowledged. The NCCR FINRISK is a research programme supported by the Swiss National Science Foundation. Parts of this research were undertaken while Beiner was a visiting scholar at the Saı¨ d Business School at the University of Oxford; he acknowledges financial support from the Swiss National Science Foundation (SNF). All remaining errors are our own.
# 2006 The Authors Journal compilation # 2006 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148,r, Wolfgang Drobetz, Markus M. Schmid and Heinz Zimmermann
1. Introduction
Is the quality of firm-level corporate governance priced in stock markets? Does ‘good’ corporate governance cause higher stock market valuations? Or are firms with higher market values more likely to choose better governance structures, for example, because they have better investment opportunities and rely more heavily on external financing? If there was a causal relationship between corporate governance and firm valuation, is the effect economically significant for corporate decision makers and fund managers to pay attention? Given that a firm can choose from a menu of corporate governance mechanisms, are there possible substitution effects? Specifically, is the greater use of one specific governance mechanism positively related to firm value, or do different combinations of mechanisms lead to equal firm valuations? Finally, do the newly adopted codes of best practice help to construct a reliable corporate governance index? These issues are addressed in this paper using a comprehensive sample of Swiss firms.