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More Rules, Higher Profits?

New research shows that good governance practices may reduce your cost of capital.
Don Durfee, CFO Magazine
August 1, 2006

All too often, the drive for corporate-governance reform feels like a costly exercise in wishful thinking. After all, can you really find a strong correlation between a mandatory retirement age for directors and a bigger net profit margin?

You can, as it happens. A growing body of research suggests that the governance practices promoted by such proxy groups as Institutional Shareholder Services (ISS) and the Investor Responsibility Research Center are indeed associated with better corporate performance and a lower cost of capital. One 2003 study by researchers at Harvard University and the Wharton School found that companies with greater protections for shareholders had significantly better equity returns, profits, and sales growth than others. Amore recent study, by ISS, found that companies that closely follow its governance advice have higher price-earnings ratios.

Not all provisions, however, are equally important. Researchers at Georgia State University found that out of 51 corporate-governance factors, only 13 (including stock-ownership guidelines for directors and executives, having a majority of independent directors, and avoiding option repricing) improved performance. And some provisions are downright harmful. One in particular will resonate with CFOs: rules discouraging companies from hiring their auditors to perform additional consulting services for a company. Those that pay their auditors less in consulting fees than in audit fees had a lower net profit margin and ROE.

Such findings are open to question. The most common complaint is that what's good for the average company may not be good for all. A mandatory retirement age, for example, could prematurely force out a wise director. CFOs, however, may have to go to great lengths to convince shareholders of that. If certain reforms can yield 12 percent higher stock returns over five years, as one study suggests, most investors will conclude that good governance is a good thing.





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