Market valuations and corporate governance - is there any linkage?

By Sardul Seth, Partner-Advisory Services, EY

In current day and time when PE multiples are defying stock market logic and valuations commanded by certain start-ups are making traditional businesses look unattractive; any conversation around corporate governance with these new billionaires is seen with an obvious scepticism of "what will change if the principles of corporate governance are stringently followed - since, we already doing so well?"

To set the context, corporate governance is supposed to be a mechanism by which the Board of Directors of a company enforces a working plan upon the executive management with the ultimate goal of maximizing the interest of all stakeholders.

However, somehow, corporate governance has always been considered a secondary factor influencing a company performance and an underdog in determining a company's valuation.
Corporate governance practices are considered important only during special events like Mergers and Acquisitions, change in the company's top-level management, reported malpractices/fraud and/or where rapid and effective integration of new policies with existing ones is required.

However, if many scandals of the 21st century have taught us anything, it is that boards and promoters cannot afford to overlook the aspects of corporate governance which may play a key role in protecting company's valuations, besides other important things.

If one reflects upon the large corporate governance scams in India during the last 20 years, one will see a trend of exciting PE multiples, electric growth trajectory, strong market valuations etc but compromised governance standards. It took a few Governance breaches for these companies to not only lose billions of dollars of investors wealth, but also pretty much eradicate the long term valuation that was built over many years.

Infact, in the last 90 days one of the factors impacting the market volatility (in both Indian and overseas markets) is mistrust that the market has on a few stock counters due to underlying governance concerns. While these counters take the beating, the overall investment sentiment is compromised resulting in exodus of FII funds, in turn eradicating investor's wealth. If one studies some of the Large Cap players in India with good governance track record, their volatility vis-à-vis market events is limited. This is a positive assurance that a good governed counter is less volatile and certainly protects investor's wealth.

The lessons

* 'Wealth protection' is as important as 'wealth creation' - the valuations triggered by potential and vision need to be protected by effective monitoring of the execution

* It is important to constantly challenge the governance principles and their adequacy to protect stakeholders wealth

However, corporate governance is not only to protect 'what you have'. It can also create positive impact on the economic parameters if adequately proven and demonstrated to the investor community.

A highly acclaimed model on 'Corporate Governance and Firm Valuations' was developed by two leading Hong Kong based professors by going through historical data of top companies. As per the model companies with

*Well defined lines of defence with clear roles and responsibilities;

*Effective entity level controls and 'Tone at the Top;

*Positive governance culture;

*Strong transparency focus; and

*Open stakeholder communication have more impetus for the investors to pay premium on

The study highlighted that such companies command multiple basis points premium over their competitors with similar economic benchmarks but poor governance outlook. Another known phenomenon is something called as the 'Korea discount' - this largely is the low valuation of South Korean companies relative to their developed-country peers due to corporate-governance effects. In the recent times, some of these companies have started 'neutralizing' the 'Korea discount' on back of strict enforcement of recent corporate governance reforms.

Thus, good corporate governance can indeed be an effective booster to the PE multiples and script valuation that the companies command. It may not directly correlate to the last digit in the bottom-line but it surely does make an impact when investors are considering 'whether an investment is worth the risk.

The more comfortable the investors are not only with the outlook/potential/strategy, but also the execution/sustenance of the strategy through well governed machinery, the more they will invest in the counter. This in-turn will impact the overall trading and/or private placements at successive premiums, in nutshell creating increased valuations.

(Views expressed are his personal)