Corporate governance might not substantially increase a firm's value, but the absence of good governance will surely have severe consequences in the long run
Relying heavily on quantitative research is not always a good idea for any analyst. Poor corporate governance historically caused disastrous situations in the capital market of many countries. Analysts should confirm that a company has good governance before releasing its valuation report. It might be an efficient way to safeguard the wealth of investors.
Although the valuation of businesses is conducted using various quantitative measures, i.e., absolute and relative valuation, we often undermine the importance of a qualitative measure, corporate governance.
Corporate governance refers to the practices, regulations, and essential processes that work as an internal control system of a company. The critical motives behind establishing such a system are to make sure that all the stakeholders' interests are balanced, and no conflicts arise that could hamper a company's business.
These stakeholders – namely, the sponsors and shareholders, management, customers, suppliers, lenders, government agencies, and other pressure groups – influence the business differently. From the analytical perspective, management and alignment of their interest can affect the enterprise value in the longer term, and analysts should consider it.
Corporate governance strength is a significant qualitative measure, and it is a good idea to start the initial screening with corporate governance for many reasons. To begin with, the corporate governance practices in a company reflect the quality of the management. Diverse and robust management could drive a business to success even with challenging startup ideas.
In contrast, inefficient management due to poor corporate governance leads to the dissolution of many profitable companies in the long run. Another point is that good governance ensures maximum transparency and disclosures, which are crucial for analysts' due diligence on a particular company. Companies with poor Corporate Governance tend to avoid disclosures that can impact the investment decision negatively. As a result, analysts fail to conduct adequate research.
Lastly, a slow yet sustainable growth model for business is a far better investment option than a rapid growth but unsustainable one. Corporate governance plays a vital role in ensuring sustainability by efficiently controlling the internal processes. Thus, every analyst should perform thorough due diligence on a company's corporate governance before going into its stock valuation.
Conducting due diligence on corporate governance requires decent knowledge of relevant laws and regulations. A good starting point could be exploring the regulators' rules and regulations issued from time to time.
All publicly listed companies in Bangladesh must adhere to the 'Corporate Governance Code (CGC) 2018' enacted by the Bangladesh Securities & Exchange Commission (BSEC), and with other applicable laws. Financial institutions are required to follow the 'Good Governance Guideline' issued by the Bangladesh Bank, in addition to the former. Meanwhile, insurance companies must follow the Insurance Act of 2010, and other regulations promulgated by the Insurance Development & Regulatory Authority (IDRA).
Thus, we need to be cautious about the primary regulator of that sector. These regulations can guide an analyst to address the non-compliance of a company's management and decide whether those can negatively impact the company's valuation. We can also review the compliance status with these rules, which can be found in the companies' annual reports. A non-compliance with light explanation is generally a red flag that requires further investigation.
In the next stage, checking some key areas can tell us a lot about the strength of a firm's corporate governance. Firstly, in the board structure, we should especially check for diversity in the expertise, age, the size of the board, the number of family members, and the independent directors' profile. Ownership concentration is another factor to consider. If the ownership is highly concentrated, we can assume that the party mostly influences the decisions. We can also research on major investors or lenders of the company. Their portfolio companies, investment philosophy, etc. can help an analyst understand the company's governance reliability.
Additionally, we may also consider the management's attitude towards engaging shareholders and analysts through different events. The last and most rigorous area to assess is the extent of disclosure made in the supplementary notes to its financial statement. If a financial statement is more compliant with the IFRS/IAS, the valuation range is also more reliable. Analysts can skim through the company's annual reports, directors report to the shareholders, management discussion and analysis, research reports, or proxy statements to inspect these issues.
Corporate governance might not substantially increase a firm's value, but the absence of good governance will surely have severe consequences in the long run. Analysts and investment professionals play a vital role in the investment sector by valuing companies and recommending to investors. So, the assessment of corporate governance is a must before issuing any recommendation. It becomes more crucial when the investment horizon is longer.
Rokibul Islam Bin Yousuf, FMVA, is an investment banking professional.