The separation of ownership and control is a fundamental problem present in all large companies. By giving control over day-to-day business matters to management, the owners of the company (the shareholders) run the risk that a company is not managed in a way that is consistent with the maximisation of their interest. A prominent example of the agency problem is the consumption of perquisites by managers. While it may be beneficial for a manager to use company resources to pay for a lavish office or a company aircraft, shareholders would perhaps prefer a more productive use of the firm’s resources. There are a number of measures that shareholders can take to either exert effective control over the managers’ activities or to align management’s interests with those of shareholders. The combination of all these measures is usually subsumed by the term “corporate governance”. However beneficial better corporate governance may be, its implementation is often accompanied by considerable costs for a firm as evidenced by the costs that governance improvements mandated by the Sarbanes-Oxley Act of 2002 imposed, especially on smaller firms. It thus remains an empirical question whether the implementation of corporate governance measures can benefit a company overall or the costs outweigh the benefits. The question is remarkably timely with many governments around the world putting in place more stringent corporate governance laws in the wake of the financial crisis, most notably the US, where the Dodd-Frank Act passed in 2010 includes several governance-related items.

Recent evidence on the beneficial effect of corporate governance is reported in our paper “Corporate Governance and Firm Value: International Evidence”, published in the Journal of Empirical Finance in January 2011. In this paper, we investigate whether companies that implement better corporate governance are rewarded by capital markets by means of a higher firm valuation. To construct a measure of corporate governance on the firm level, we use a database compiled by Governance Metrics International (GMI), which assembles information on 64 individual corporate governance attributes for roughly 2,000 companies from 22 countries for the time period from 2003 until 2007. The 64 attributes are classified into six different categories, namely board accountability, financial disclosure and internal control, shareholder rights, remuneration, market for control, and corporate behaviour. As an example, one attribute in the category “board accountability“ indicates if a board consists of more than 50% of independent directors. If this is not the case, it is interpreted as a sign of bad corporate governance since one mechanism to control the CEO is potentially weakened.

Combining the 64 individual measures into a corporate governance index, we empirically test if companies with a higher governance index have a higher firm value. Using many different statistical tests, we find a positive effect of better corporate governance on firm value. Therefore, if a company implements more measures to strengthen the quality of its corporate governance, it can expect a reward by capital markets in the form of a higher firm valuation. This finding holds for our whole time period as well as for individual years and also for all sample countries combined as well as for the majority of individual countries.

Over the last few years, there has been much debate about companies’ corporate social responsibility. The richness of the GMI dataset allows us to investigate whether this particular aspect of corporate governance also has an effect on firm valuation. As indicators of corporate social responsibility we use variables that indicate, for example, if a company has a policy addressing workplace safety, if a company discloses its environmental performance, or if a company discloses its policy regarding corporate level political donations. Combining these attributes to a measure of corporate social responsibility, we find that companies with better corporate social responsibility are more highly valued than companies with comparatively worse corporate social responsibility. The value relevance of these attributes is also robust to controlling for the effect of standard corporate governance attributes. Moreover, we find that the positive valuation effect of corporate social responsibility is restricted to firms with a good corporate governance structure. Hence, good corporate governance seems to assure that corporate social responsibility expenditures are profit-oriented rather than serving the managers’ personal ambitions, for example to improve their reputation as good global citizens.