Some understanding of each area of governance is needed for the approach to be optimal. There can be considerable variation in how the evaluation is accomplished. For example, some areas are best dealt with as part of the rating process (including management expertise, risk management processes and contribution of the board of directors or other governing body), while others are important for determining the reliability of information used in the rating process (including financial reporting, audit processes and transparency of company disclosures). There is also a wide variety in terms of complexity, subjectivity and measurement. Issues of ownership and management compensation are relatively easy to measure, although evaluation is complex. Transparency and openness are somewhat less straightforward, while an assessment of appropriate board oversight, management expertise, completeness and independence of the audit process and the effectiveness of the audit committee can be quite subjective.
When an entity exhibits weakness in a governance issue, it may affect the rating by raising questions with respect to certain areas, such as the accuracy and reliability of its financial statements. Some entities may also face a wide range of regulatory penalties that could affect both financial results and the ability to continue and/or expand a business.
Sample and descriptive statistics
Due to the focus on governance measures, our sample is restricted to top 100 firms in Mauritius. We create a summary metric, Gov.-Score, to measure the strength of a firm's governance. We compute Gov.-Scores for 100 individual firms. Using data obtained from the registrar of companies and business magazines we code 51 factors as either 1 or 0 depending on whether the firm's governance standards are minimally acceptable. We then sum each firm's 51 binary variables to derive Gov.-Score.
Gov.-Score is a composite measure of 51 factors encompassing eight corporate governance categories: audit, board of directors, charter/bylaws, director education, executive and director compensation, ownership, progressive practices, and state of incorporation. We relate Gov-Score to operating performance, valuation, and shareholder payout for firms, and we find that better-governed firms are relatively more profitable, more valuable, and pay out more cash to their shareholders. We examine which of the eight categories underlying Gov-Score are most highly associated with firm performance. We show that good governance, as measured using executive and director compensation, is most highly associated with good performance. In contrast, we show that good governance as measured using charter/bylaws is most highly associated with bad performance. We examine which of the 51 factors underlying Gov-Score are most highly associated with firm performance. Some factors representing good governance that are associated with good performance have seldom been examined before (e.g., governance committee meets annually, independence of nominating committee). In contrast, some factors representing good governance that are associated with bad performance have often been examined before.
We will then consider six performance measures spread across three categories: operating performance, valuation and shareholder payout. We select the three operating performance measures, return on equity, profit margin and sales growth; Tobin's Q, the single valuation measure considered economics, finance and law researchers (e.g., Demsetz and Lehn 1985; Morck, Shleifer and Vishny 1988; Bebchuk and Cohen 2003; Bebchuk, Cohen and Ferrell 2004); and two measures of shareholder payout, dividend yield and share repurchases, respectively used by Fenn and Liang (2001) and Dittmar (2000).
Performance measures to be used:
Operating performance
Return on Equity = Income Before Extraordinary Items Available for Common Equity / Average Total Common Equity
Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. If you think back to lesson three, you will remember that shareholder equity is equal to total assets minus total liabilities. It's what the shareholders "own". Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owners.
Net Profit Margin = Income Before Extraordinary Items Available for Common Equity / Net Sales
Net profit margin is a ratio comparing net profit after taxes to revenue. Investors can calculate the net profit margin by using the income statement.
Sales Growth = (Net Salest - Net Salest-1) / Net Salest-1.
VALUATION
Tobin's Q = (Total Assets + Market Value of Equity * Common Shares Outstanding) - Total Common Equity- Deferred Taxes (Balance Sheet)) / Total Assets
Tobin's Q Theory is generally accepted as being a reliable means of evaluating the market level of a company. Some economists, however, believe that the Q theory is best utilized in conjunction with other economic theories when it comes to evaluating future actions on the part of a company. From this perspective, Tobin's Q Theory is understood as being one of several valid indicators that can help owners and management to plan for future action while not necessarily dictating a specific action.
SHAREHOLDER PAYOUT
Dividend Yield = Dividends per share - Payable Date / Stock Price Fiscal Year Close.
A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position.
Share Repurchases = (Purchases of Common and Preferred Stock - Decrease in Preferred Stock (from previous year)) / Market Value of Equity.
A program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This is usually an indication that the company's management thinks the shares are undervalued. Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares. When a company does repurchase shares, it will usually say something along the lines of, "We find no better investment than our own company
Methodology:
We begin with two types of cross-sectional analyses. We first correlate Gov- Score with each industry-adjusted fundamental variable using Pearson and Spearman correlations. We then order Gov-Scores from highest to lowest (i.e., from best to worst governance), and see if firm performance differs in the extreme governance deciles. For example, when we examine return on equity, we compare industry-adjusted return on equity for firms in the top Gov-Score decile with those in the bottom decile, and we use a t-test to determine if the mean values of return on equity in the top and bottom deciles of Gov-Scores differ significantly. To assess which categories and factors are associated with expected/unexpected (good/bad) performance, we correlate the six performance measures with the eight governance categories and 51 governance factors. We consider a category or a factor to be associated with good/bad (expected/unexpected) performance if it is positive/negative and significant at the 10% level or better using a one-tailed test.
