Putting a value on governance.

• Author: Felton, Robert F.
• Position: Includes related article

Good board governance can serve as a tool for attracting certain types of investors as well as influencing what they will pay for stock.

Says the CEO of a Fortune 500 company: "The board governance fad is being kept alive by a bunch of consultants and academics...there is no evidence that board governance matters to shareholders. When I see some evidence, I'll take this more seriously."

This CEO is not alone in his skepticism. Though there are some CEOs who firmly believe in the importance of good board governance and have taken steps to strengthen their company's governance processes, many others remain doubtful about the benefits of taking action. "So many other things matter more - competitors, financials, marketing - board governance is just not on my screen," said one CEO. Another argued, "Fund managers are very short-term oriented; not much use talking about boards with them - it's too long-term an issue."

To try and ascertain the real worth of good governance, McKinsey & Co., in conjunction with Institutional Investor Inc., conducted a survey of over 100 major investors, CEOs, and senior executives. For the purpose of the survey, well-governed companies were defined as having, as a minimum:

* A clear majority of outsiders on the board.

* Truly independent directors with no management ties.

* Directors who hold significant stock holdings and who are paid, to a large extent, in stock.

* Directors who are formally evaluated.

* Boards that are responsive to investor requests.

According to the survey findings, good governance practice really does make a difference - a difference that many investors are willing to pay for.

Just how much is it worth?

We asked investors to compare two well performing companies (such as those with consistent profits and number one or two in terms of market share) and state whether they would pay more for the stock of one of these companies if it were well governed. Two-thirds of the investors said they would (Exhibit 1). As one respondent put it: "Companies with good board governance practices have a shareholder-value focus."

Among those willing to pay more for good governance, the average premium specified was 16%. However, a minority of those investors who said they would pay more felt the actual premium was hard to quantify. Based on the entire survey group, including those who said they would not pay more, the average premium was 11%. An 11% increase in share price would equate to an increase in earnings before interest and taxes (EBIT) of 11% in perpetuity.

Who cares most?

If it is clear that many investors are willing to pay significantly more for the stock of companies that have good governance practices, how can those investors be identified? The survey reveals three key variables that influence the importance certain investors place on good governance:

Portfolio turnover. Investors with lower turnover ratios in their portfolios value governance most. They hold stocks longer and believe good governance will help improve performance in the long term.

Asset management philosophy. Investors who pursue a value strategy (for example, those who invest in undervalued companies with low price/earnings ratios and/or stable companies with regular dividends), are more willing to pay for good governance than those who pursue a growth strategy (for...