Empirical Evidence on Corporate Governance in

Europe

The Eect on Stock Returns, Firm Value and Performance

Rob Bauer

Nadja G unster

Roger Otten

October 23, 2003

(forthcoming in the Journal of Asset Management)
Abstract
In this paper we analyze whether good corporate governance leads to higher com-
mon stock returns and enhances rm value in Europe. Throughout this study we
use Deminor Corporate Governance Ratings for companies included in the FTSE
Eurotop 300. Following the approach of Gompers et al. (2003) we build portfolios
consisting of well-governed and poorly governed companies and compare their per-
formance. We also examine the impact of corporate governance on rm valuation.
Our results show a positive relationship between these variables and corporate gover-
nance. This relationship weakens substantially after adjusting for country dierences.
Finally, we analyze the relationship between corporate governance and rm perfor-
mance, as approximated by Net-Prot-Margin (NPM) and Return-on-Equity (ROE).
Surprisingly, and contrary to Gompers et al. (2003), we nd a negative relationship
between governance standards and these earnings based performance ratios for which
we discuss possible implications.
Keywords: Corporate governance, asset pricing, equity returns, rm value, performance
attribution, and protability ratios.

We would like to thank Roderick Molenaar for constructing the factor portfolios and his helpful
suggestions throughout the research process. Moreover, we appreciate Vishal Jadnanansings help in
obtaining the nancial data. We appreciate the comments of Mathijs van Dijk, Jeroen Derwall, Christian
Kerckhos, and Dariusz Wojcik. We are grateful to Deminor Rating, Brussels, for providing the corporate
governance ratings. All remaining errors are our sole responsibility.

Rob Bauer is aliated with ABP Investments and Maastricht University.

Contact Author: Nadja G unster, Rotterdam School of Management, Department Financial Manage-
ment, Erasmus University Rotterdam, Postbus 1738, 3000 DR Rotterdam, e-mail: nguenster@fbk.eur.nl,
phone: +31-10-4082762.

Roger Otten is aliated with Maastricht University.

1
1 Introduction
Promoted by corporate scandals such as Enron and WorldCom in the United States (U.S.),
Marconi in the United Kingdom (U.K.), and most recently Royal Ahold in the Netherlands,
corporate governance has received a lot of attention in the nancial community. Institu-
tional investors have started evaluating which role corporate governance should play in
their investment policies. The McKinsey Global Investor Opinion Survey shows that
15% of European institutional investors consider corporate governance as more important
than a rms nancial issues, such as prot performance or growth potential. Additionally,
22% of European institutional investors are willing to pay an average premium of 19% for
a well-governed company.
1
Although this evidence demonstrates the interest in corporate
governance, the important question whether good corporate governance leads to higher
stock returns and consequently to higher rm valuations has received limited attention in
the academic literature.
For the U.S. market, Gompers et al. (2003) analyze the relationship between corporate
governance and long-term equity returns, rm value and accounting measures of perfor-
mance. Their results clearly support the hypothesis that well-governed companies out-
perform their poorly governed counterparts. Well-governed companies have higher equity
returns, are valued higher and their accounting statements show a better operating perfor-
mance. These ndings should encourage investors in U.S. companies to consider corporate
governance in their investment decisions.
Relatively few studies on this issue have investigated the European case. We intend
to ll this gap. Following Gompers et al. (2003) we build portfolios consisting of well-
governed companies and compare their long-term equity returns to portfolios composed of
poorly governed rms on a style-, country- and sector-adjusted basis. Subsequently, we
examine the impact of corporate governance on rm valuation as measured by Tobins q.
Finally, we analyze the eect of corporate governance on rm performance. We use two
1
Source: McKinsey and Company, July 2002, McKinsey Global Investor Opinion Survey on Corporate
Governance, Key Findings, Exhibit 1, 3 and 4, available on: www.mckinsey.com .
2
earnings based ratios to approximate rm performance: Net-Prot-Margin (NPM) and
Return-on-Equity (ROE).
Although we examine similar hypotheses as Gompers et al. (2003), our research design
diers in various aspects. This is mainly due to the dierent dataset available for Europe.
Since our dataset consists of two currency areas, the U.K. and the European Monetary
Union (EMU), we decided to analyze them separately. Besides, this approach gives signif-
icant insight regarding the dierent impact of corporate governance in these two regions.
Throughout our research we will use the corporate governance ratings of Deminor, which
cover most companies included in the FTSE Eurotop 300. An advantage of our dataset
is that Deminor is evaluating approximately 300 dierent governance criteria per rm.
Therefore, the data provide a very comprehensive description of each rms governance
system. The main drawback is however that we have ratings for only two years, 2000 and
2001. To overcome this problem we extend our analysis backwards assuming constant gov-
ernance ratings for a limited number of years. As shown in the data description in section
3, this approach seems reasonable.
The remainder of this paper is organized as follows. Section 2 briey summarizes em-
pirical research on corporate governance. Section 3 provides a description of the database
that is used throughout our analysis. In section 4, we present our main empirical results.
Finally, in section 5 we draw conclusions and discuss the implications of our results for
investors.
2 The empirical corporate governance literature
We structure this brief survey of prior empirical research along three lines.
2
Firstly, we
discuss research on the relationship between long-term equity returns and corporate gov-
ernance. This is followed by an overview of empirical research on the association between
2
This survey is not meant to be a complete overview of prior research performed on the topic of
corporate governance. Instead, we will shortly discuss recent papers, which closely relate to our research.
For a more extensive overview, see for example Becht et al. (2002).
3
corporate governance and rm value. Finally, we pay attention to the impact of corporate
governance on rm performance.
Two closely related academic studies focusing on corporate governance and long-term
equity returns are Gompers et al. (2003) and Drobetz et al. (2003). Gompers et al. (2003)
analyze the impact of 24 governance provisions on stock returns for about 1500 U.S. rms
from 1990 till 1999. They construct portfolios consisting of rms with numerous anti-
takeover amendments (Dictatorship Portfolio) and portfolios including rms with very
few amendments (Democracy Portfolio). Subsequently, they examine the returns to
holding a long position in the Democracy Portfolio and a short position in the Dictator-
ship Portfolio. This long-short strategy yields an average annual return of about 8.5% after
adjusting for factor exposures of the portfolios using the Carhart (1997) model. Drobetz
et al. (2003) analyze the impact of corporate governance on stock returns over the period
1998-2002 in Germany. Due to the fact that their corporate governance data are limited
to one observation, March 2002, they assume constant historical ratings. To construct
their sample, Drobetz et al. (2003) sent out questionnaires to 253 German rms in dier-
ent market segments and received answers from about 36% of these rms. In line with
Gompers et al. (2003), Drobetz et al. (2003) also build factor portfolios consisting of well-
governed versus poorly governed rms. After accounting for dierent factor exposures of
the portfolios, their results show an amazing annual excess return of 16.4% to a corporate
governance long-short strategy.
The empirical literature on the relationship between rm value and corporate gover-
nance usually analyzes either dierences among countries and their impact on rm value
or inter-rm variation within a country. The most prominent example of the rst type of
study is LaPorta et al. (2001), who investigate dierences in governance standards among
27 countries. Their evidence shows that rms incorporated in countries with better gover-
nance standards tend to have a higher valuation. Examples of the second type of studies
investigating inter-rm variation within one country are Drobetz et al. (2003) for Germany,
Gompers et al. (2003) for the U.S., de Jong et al. (2002) for the Netherlands and Black
(2001) for Russia. These studies generally nd a positive relationship between governance
4
standards and rm value. Comparing the ndings of these studies, it is worth noting that
the relationship seems to be stronger in countries with less developed standards.
There is rather few empirical literature which examines the impact of a complete set
of governance standards on rm performance approximated by protability ratios. Most
studies instead investigate the impact of a single governance characteristic on rm perfor-
mance.
3
Again, we follow the approach of Gompers et al. (2003). Their evidence shows
that superior governance standards positively impact rm performance as measured by
Net-Prot-Margin and Return-on-Equity in the U.S.
3 Data Description
To measure the companies quality of governance we use Deminors corporate governance
ratings. The ratings cover between 249 and 269 rms included in the FTSE Eurotop 300
over the time-period 2000 till 2001.
4
They are based on about 300 dierent criteria, which
can be attributed to four broader categories: Rights and Duties of Shareholders, Range
of Takeover Defenses, Disclosure on Corporate Governance and Board Structure and
Functioning. In turn, we will give a short overview of each category and show some
descriptive statistics, which give considerable insight into the characteristics of our data.
Within the rst category Rights and Duties of Shareholders, Deminor evaluates
whether shareholders can exert sucient power to determine corporate action. Demi-
nor assesses for instance whether the voting structure of the company and its procedures
are favorable for shareholders. Shareholders should be able to le items on the agenda
and counterproposal before as well as during the General Meeting. Further, according
to Deminors standards, the preemptive rights of existing shareholders should be guaran-
teed to ensure that their voting power cannot be diluted. The second category Range of
Takeover Defenses evaluates whether the likelihood of a hostile takeover is signicantly
3
Examples of such studies are for instance Yermack (1996) and Adams and Mehran (2002), who inves-
tigate the impact of board size on rm valuation and rm performance.
4
For the remaining rms Deminor did not provide ratings since the information available was insucient.
5
decreased by the adoption of antitakeover amendments. According to Deminors rating
standards, incumbent management should not be able to block a takeover attempt at the
expense of shareholders. Category three Disclosure on Corporate Governance measures
whether shareholders are able to obtain convenient and comprehensive information about
the companys nancial matters as well as its governance characteristics. For instance,
the rm should release information on their board members, structure and committees
as well as its remuneration and stock option plans. Within category four, Deminor an-
alyzes the rms board structure and functioning. Important evaluation criteria in this
category are the composition and election of the board members as well as remuneration
and functioning.
To examine whether companies performing superior in one of these categories also tend
to outperform with respect to another category, we analyzed the cross-sectional correlations
of the four dierent categories. With the exception of Rights and Duties of Shareholders
all categories are signicantly correlated. As expected all categories are also signicantly
correlated with the total rating. These results clearly show that superior (or inferior)
governance standards tend to persist across dierent dimensions. We will therefore focus
on the companies overall governance rating.
Governance standards do not only seem to be persistent across dierent dimensions, but
also over time. The time-series correlations of the 4 categories as well as the total rating are
well above 0.8 and signicant at the 1% level. Despite the fact that it would obviously be
an improvement to have data available for a longer time horizon, these ndings support our
assumption of constant relative governance ratings over time. Throughout the empirical
analysis we will employ the 2000 ratings backwards until 1997 to obtain meaningful results.
5
To explore whether sectors or countries dier among each other with respect to their
governance standards, we present sector and country averages in Table 1 and Table 2,
5
We are aware that this procedure will introduce look-ahead bias and survivorship bias in our analysis,
but given the constrained data history we perceive extending the ratings backwards as the best possible
solution. To reduce the impact of these biases on our results, we limit the time period to a maximum of
four years.
6
respectively. It is interesting to note that there are large and statistically signicant dif-
ferences among countries. Dierences among sectors remain rather small. These ndings
suggest that corporate governance is strongly determined by country law. Throughout
the empirical analysis we will adjust for country as well as sector eects. Although sector
eects seem to be rather small in the corporate governance ratings, we want to ensure
that our results are neutral with respect to sector exposures. Besides, our nancial data,
such as stock returns, Tobins q, Return-on-Equity etc. might also be inuenced by sector
eects.
The nancial data we employ in our analysis are commonly used in academic research.
We obtained these data from dierent Factset libraries, mainly from Worldscope. When-
ever appropriate, we use nancial data in the empirical analysis, which were publicly
available at the respective point in time to avoid look-ahead bias.
4 Empirical Analysis
4.1 Corporate Governance and Stock Returns
To analyze the impact of corporate governance on equity returns we constructed value-
weighted corporate governance factor portfolios. All rms were ranked on the basis of
their corporate governance rating for the European Monetary Union (EMU) and the U.K.
sample, respectively. For the EMU, we assign the 20% of companies with the highest
corporate governance rating to the Good Governance Portfolio. The bottom 20% is
allocated to the Bad Governance Portfolio. For the U.K. we build quartiles instead of
quintile portfolios due to the smaller size of the sample. In our portfolio construction
method we deviate from Gompers et al. (2003). They construct their portfolios based on
the absolute score of a rm while our portfolios are determined by the relative score of a
rm versus the complete sample. In this way we ensure that our portfolios are about equal
with respect to total market capitalization.
From these portfolios, we compute equally weighted returns to a zero investment strat-
7
egy.
6
The investor is holding a long position in the Good Governance Portfolio and a
short position in the Bad Governance Portfolio. Without any adjustments for market
risk or diering rm characteristics, this zero-investment strategy leads to an annual re-
turn of 2.1% for the EMU portfolio and 7.1% for the U.K. portfolio from January 1997 till
July 2002. Thus, a zero investment portfolio would have earned a positive return in both
regions. The central question is whether this nding can be explained by market risk and
other common factors determining common stock returns or whether it is attributable to
dierences in governance standards.
As documented by Fama and French (1992, 1993) stock returns are, next to market
risk (beta), aected by a rms market capitalization (size) and book-to-market ratio
(value versus growth). Jegadeesh and Titman (1993) showed that future returns might
also be inuenced by past returns (momentum). To account for these factors, we will
employ the Carhart (1997) four-factor model, which is estimated by:
R
LSt
= +
1
(R
mt
R
ft
) +
2
SMB
t
+
3
HML
t
+
4
MOM
t
+
t
(1)
where R
LSt
is the excess monthly return of the zero-investment portfolio, R
mt
is the monthly
return on the market portfolio and R
ft
is the monthly risk-free interest rate. SMB
t
(Small
Minus Big) is the monthly return on a size factor portfolio. HML
t
(High Minus Low) is
the monthly return on a book-to-price factor-mimicking portfolio based on the book-to-
market ratio. MOM
t
(Momentum) is the monthly return on a momentum factor portfolio.
The constant, , represents the excess return an investor could have earned pursuing this
investment strategy.
We construct the factor portfolios SMB and HML following the method of Fama
and French (1993). In line with the corporate governance portfolios they are built value-
weighted. The SMB portfolio is based on the rms market capitalization at the end of
June. The companies with the lowest 30% of market capitalization are dened as Small.
The top 30% of rms are dened as Big. The return on the portfolio of Big companies
6
We compute equally weighted instead of value-weighted returns to avoid larger companies determining
our ndings.
8
is subtracted from the return on the small cap portfolio. The HML factor-mimicking
portfolio is constructed in a similar way. The 30% of companies with the highest book-to-
market ratio are included in the value portfolio. The bottom 30% is dened as growth
portfolio. The return on the growth portfolio is subtracted from the return on the value
portfolio.
MOM is generally constructed as dened by Carhart (1997).
7
To construct the MOM
portfolio, the 30% of rms with the highest eleven-month returns lagged one-month are
classied as winners. The bottom 30% is classied as losers. Each month the return
on the losers portfolio is subtracted from the return on the winners portfolio.
8
The results of estimating equation 1 are shown in Table 3. The rst row presents the
regression estimates for the U.K. As indicated by the alpha, the performance dierential
between the Good Governance and the Bad Governance Portfolio is about 6.8% annually.
With respect to size, value versus growth, and momentum the portfolios do not seem to
dier substantially. The only signicantly positive coecient is
1
, which reveals that the
good governance portfolio has a higher exposure to market risk than the bad governance
portfolio. The EMU results look very dierent from the U.K. results. The alpha decreases
after adjusting for factor exposures from about 2.1% to 1.6%. A large part of the per-
formance dierential documented above can be attributed to dierences in size, style and
momentum. As shown by the positive value versus growth coecient and the negative size
coecient, well-governed companies can be classied as large-cap value in the Eurozone.
The highly signicant HML coecient indicates that sector eects might bias results. To
sector adjust the returns of the corporate governance portfolios, we subtract the respective
sector return from each rms return and add the market return. The factor portfolios for
this specication are constructed sector neutral. The results of sector-adjusted regressions,
shown in Table 3 (row 3 and 4) support the proposition that sector exposures aected the
7
The main dierence is that Carharts momentum portfolio is built equally weighted, while the portfolios
in this analysis are constructed value-weighted. Since all other factor portfolios in this analysis are built
value-weighted, for consistency the MOM portfolio is value-weighted as well.
8
The construction of these factors was done using the online research tool by Style Research Ltd.
9
results of the EMU sample. After sector adjusting, dierences in style between the good
and bad governance portfolio are eliminated. The HML coecient basically equals zero.
Further, the alpha increases to about 3.0%. The U.K. alpha declines to about 4.6% after
sector-adjustments.
Since the descriptive statistics, discussed in section 3, indicated that the corporate gov-
ernance ratings exhibit signicant country dierences we also adjust for country exposures
of the portfolios. To adjust the returns of the corporate governance factor portfolios for
country eects, we employ the same procedure as previously in the sector-adjusted analysis.
The respective country return is subtracted from each rms return and the market return
is added. While we estimated the sector returns based on our own sample, the return of
each country included in the EMU portfolios is represented by the respective MSCI country
index. The reason is that the sample size for some countries is extremely small. For exam-
ple, Portugal is represented in the 2000 portfolios with only three companies. Computing
a country return from such few observations, would not be a realistic proxy of the return
of the countrys stock market. Instead, we use the respective MSCI country index. As
previously shown in the sector-adjusted analysis, the factor mimicking-portfolios for size
(SMB), style (HML) and 12-months return momentum (MOM) are also constructed
country neutral. The results are presented in Table 3 (row 6). It is striking to see that the
HML coecient again becomes positive and highly signicant. This indicates that sector
eects again inuence the results. The alpha reduces to about negative 1.0%.
Overall, we nd some evidence that corporate governance aects common stock returns
positively. For the U.K. sample, the regression constants () are consistently positive,
though statistically insignicant at the 95% level. Comparing our results for the U.K. to
those of Gompers et al. (2003) for the U.S., we observe that the size of the constants is
similar. One main dierence is that they were able to collect 10 years of data. To analyze
whether our results are statistically signicant as the number of observations increases, it
would be worthwhile repeating our analysis when more years of data are available . This
is also essential to examine the robustness of our conclusions.
For the EMU sample the alphas are positive, though statistically insignicant, for most
10
specications. It seems that sector-and country eects, which require more investigation,
aect the EMU results. An avenue for further research would be to account for sector-
and country eects within one specication. This will be feasible as a longer time-series of
governance ratings is available for Europe.
9
4.2 Corporate Governance and Firm Value
If better-governed rms tend to have higher stock returns, this should in the long-run,
ceteris paribus, translate into a higher rm valuation. Consequently, we investigate in the
following to which extent corporate governance is already accounted for in stock prices.
We use Tobins q (Q
it
) as our measure of rm valuation. Tobins q is dened as the
market value of assets divided by the replacement value of assets. The market value of
assets is represented by the sum of the book value of assets and the market value of common
stock outstanding. From this the sum of book value of common stock and balance sheet
deferred taxes is subtracted. The replacement value of assets is represented by the book
value of assets. Although there are more sophisticated measures of Tobins q, we choose
this simple approximation to ensure data availability for most of our sample.
10
To separate the impact of corporate governance from other factors aecting Tobins q,
we use multivariate regression analysis. In line with Gompers et al. (2003) as well as Shin
and Stulz (2000), we account for the rms book value of assets and rm age. Further,
Daines (2001) and Yermack (1996) showed that current and past performance signicantly
aect rm valuation. Therefore, we include the rms Return-on-Equity (ROE) in the
current and in the previous year as control variables. We estimate the following cross-
sectional regression equation:
Q
it
= +
1
CG
it
+
2
BV
it
+
3
AGE
it
+
4
ROE
it
+
5
ROE
it1
+
6
SD
it
+
it
(2)
where CG
it
is the logarithm of the rms governance rating, BV
it
is the logarithm of
9
At the moment we do not consider this approach as appropriate due to the loss in degrees of freedom.
10
For a detailed discussion of dierent measures of Tobins q we refer to Erickson and White (2001) or
Perfect and Wiles (1993).
11
the Book Value of Assets and AGE
it
is the logarithm of the rms Age in years. The
foundation of the rm is approximated by the rst trading day. ROE
it
and ROE
it1
are
the rms Return-on-Equity in the current and in the previous year, respectively. SD
it
represents a vector of sector dummies. We estimate this regression equation annually from
1996 to 2001. Following Fama and MacBeth (1973), the time-series mean and t-statistics
are computed from the annual regressions. As in the previous section, we estimate the
equation separately for the two currency areas, the European Monetary Union (EMU) and
the U.K.
Table 4 presents the results. In the EMU, the impact of corporate governance on rm
value is rather strong. The coecients of corporate governance are consistently positive
in all annual regressions. The time-series coecient is signicantly positive at the 1%
level. On average, a 1% increase in the corporate governance rating results in a 0.14 %
increase in Q. The relationship between corporate governance and rm value is not nearly
as strong in the U.K . The time-series coecient is statistically insignicant and close
to zero. One possible explanation for the dierent results of the U.K. versus the EMU
sample is that the EMU sample consists of several countries. We found in section 2 that
corporate governance standards dier signicantly among countries. Therefore, the strong
CG coecient observed in the EMU could be due to country eects, which have previously
been documented by LaPorta et al. (2001). To investigate this possibility further, we
re-estimate equation (2) including country dummies:
Q
it
= +
1
CG
it
+
2
BV
it
+
3
AGE
it
+
4
ROE
it
+
5
ROE
it1
+
6
CD
it
+
it
(3)
where CD
it
represents a vector of country dummies. All other variables are dened as in
equation (2) above. The results, presented in Table 4 (column 3) are more ambiguous than
the sector-adjusted ndings. Despite the fact that the time-series coecient is still positive
and reasonable in size, it is not statistically signicant. Four of the annual coecients are
positive, of which one is statistically signicant at the ve percent level. Two are negative,
though insignicant.
Overall, these results indicate that rm valuation is positively related to the quality
12
of governance standards in the EMU. This relationship is rather strong before country
adjusting and becomes weaker after accounting for country dierences.
4.3 Corporate Governance and Firm Performance
There are generally speaking two reasons why good corporate governance increases rm
value. First, good governance increases investor trust. Investors might perceive well-
governed rms as less risky and apply a lower expected rate of return, which leads to a
higher rm valuation. Second, as shown for example by Jensen and Meckling (1976), better-
governed rms might have more ecient operations, resulting in a higher expected future
cash-ow stream. In this section, we examine the impact of corporate governance on oper-
ating eciency as approximated by the Net-Prot-Margin (NPM
it
) and Return-on-Equity
(ROE
it
). Exactly as in the previous parts we split our sample into rms incorporated in
the European Monetary Union (EMU) and U.K. rms. In line with Gompers et al. (2003)
we estimate the following regression equation:
11
NPM
it
= +
1
CG
it
+
2
BM
it
+
3
SD
it
+
it
(4)
where CG
it
is the rms corporate governance rating, BM
it
is the logarithm of the book-
to-market ratio and SD
it
is a vector of sector dummies. The regression equation employing
ROEit as measure of performance is:
ROE
it
= +
1
CG
it
+
2
BM
it
+
3
SD
it
+
it
(5)
where all explanatory variables are dened as in equation (4). We estimate these regressions
annually from 1996 to 2001. Following Fama and MacBeth (1973), we compute the time-
11
Diering from Gompers et al. (2003) we use the current year book-to-market ratio (BM). The main
problem inherent in our corporate governance data is survivorship bias. Hence, using the current year BM
minimizes this problem compared to the use of lagged accounting data. Since the main purpose of this
analysis is to nd out whether corporate governance has an impact on performance as measured by ROE
and NPM and not how good investors prediction skills are, this should not severely aect our conclusions.
Another dierence between our analysis and Gompers et al. (2003) is that we truncate our sample to
mitigate the impact of outliers. Gompers et al. (2003) perform median-deviation regressions instead.
13
series mean and t-statistics.
Table 5 presents the results of the EMU sample. Contradicting our expectations, the
time-series coecients of corporate governance are signicantly negative. In the ROE
regressions, the annual corporate governance coecients are all negative, though insignif-
icant. For NPM, ve out of six CG coecients are negative. In the U.K., our results do
not provide evidence of a relationship between corporate governance and performance. As
shown in Table 6, both of the time-series coecients are negative, but they are statistically
insignicant. Further, the annual coecients do not display a clear pattern. While there
are several possible explanations why we cannot nd a relationship between corporate gov-
ernance and performance in the U.K., the EMU results are puzzling. Prior to suggesting
possible explanations, we will investigate whether the EMU results are biased by coun-
try eects. Therefore, we re-estimated regression equation (4) and (5) including country
dummies instead of sector dummies:
NPM
it
= +
1
CG
it
+
2
BM
it
+
3
CD
it
+
it
(6)
and
ROE
it
= +
1
CG
it
+
2
BM
it
+
3
CD
it
+
it
(7)
where CD
it
is a vector of country dummies and all other variables are dened as in equation
(4) and (5) above.
As Table 7 shows, the inclusion of country dummies does not substantially alter our
ndings with respect to the EMU sample. Despite the fact, that the ROE time-series
coecient of corporate governance is no longer statistically signicant, the time-series
coecients of corporate governance remain negative for both specications. Further, the
CG coecient in the NPM regression is still signicantly negative at the 1% level.
Overall, our results with respect to the relationship between corporate governance and
rm performance in the Eurozone are contrary to our expectations. One possible expla-
nation could be that accounting numbers are biased measures of rm performance. Both
of our proxies are based on reported accounting earnings. A negative correlation between
14
earnings and corporate governance possibly implies that badly governed companies report
less conservative earnings estimates. As recent corporate scandals showed, managers tend
to use their latitude to overstate earnings. Obviously, this hypothesis requires further
investigation.
5 Conclusions and Implications
In this paper we analyzed the relationship between dierent governance standards and
stock returns, rm value, and operating performance for most rms included in the FTSE
Eurotop 300 in 2000 and 2001. Although we had a limited history of corporate governance
ratings available, our results give rst insights regarding the impact of corporate governance
in Europe.
Combining our evidence on the relationship between corporate governance and rm
value as well as equity returns, we nd substantial dierences between the U.K. market
and the Eurozone markets. While we found economically large excess returns to a zero-
investment corporate governance strategy in the U.K., we found no evidence of a relation-
ship between governance and rm valuation. This result indicates that the U.K. market is
still adjusting. In the long-run, the excess returns to corporate governance should translate
in a higher rm valuation for better governed rms. In the EMU, the excess returns to a
corporate governance strategy were much smaller, particularly after correcting for coun-
try eects. Instead, we found a stronger relationship between governance and rm value.
This evidence might imply that current corporate governance standards have, to a large
extent, already been incorporated in stock prices. The reason that investors in Eurozone
companies already accounted more for a rms governance standards than U.K. investors,
could be explained by the fact that Eurozone countries traditionally tend to have poorer
governance standards. This result is in line with prior empirical research discussed in sec-
tion 2, which also demonstrated that the lower the governance standards, the stronger the
relationship between governance and rm value.
15
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17
Table 1: Sector Deviations
Industry 2000 2001
Mean n Mean n
(t-statistic) (t-statistic)
Basic Materials and Energy 20.37 25 22.01 25
(0.83) (0.77)
Consumer Cyclical (Auto & Cyclical Goods) 18.26 25 19.22 25
(-0.85) (-1.35)
Consumer Cyclical (Media & Retail) 20.37 23 22.53 27
(0.85) (1.06)
Consumer Non-Cyclical (Good & Services) 18.73 24 21.36 29
(-0.45) (0.24)
Financial (Banks) 20.33 38 20.72 34
(0.92) (-0.32)
Financial (Financial Services & Insurances) 19.14 24 20.46 30
(-0.16) (-0.44)
Healthcare 20.79 11 20.66 14
(0.63) (-0.17)
Industrial 20.54 35 22.58 37
(1.05) (1.50)
Technology & Telecommunications 16.79 26 19.63 31
(-1.96) (-1.16)
Utilities 17.71 18 20.47 17
(-1.26) (-0.32)
Average Rating 19.39 249 21.03 269
Note:
Table 1 gives an overview of the average rating of each sector in 2000 and 2001, respectively. T-statistics
are stated in parentheses. n indicates the number of rms available for each country.The null hypothesis
is that there is no signicant dierence between the sector mean and the sample mean.
** Signicant at the 1% level.
* Signicant at the 5% level.
18
Table 2: Country Deviations
Country Mean 2000 Number of Mean 2001 Number of
(t-statistic) Observations (t-statistic) Observations
Belgium 15.16** 8 15.88** 10
(-6.34) (-6.90)
Denmark 12.46* 3 14.89* 5
(-3.29) (-2.96)
Finland 21.81 4 21.44 5
(1.02) (0.22)
France 17.94 40 20.88 39
(-1.70) (-0.12)
Germany 18.23 24 19.75 26
(-1.20) (-1.40)
Greece 16.42 3 na
(-1.04) ()
Ireland 29.40** 4 27.74* 3
(14.14) (4.79)
Italy 17.69* 24 19.03* 23
(-2.04) (-2.57)
Netherlands 13.31** 20 15.45** 18
(-7.53) (-4.40)
Norway na 15.81 3
() (-2.38)
Portugal 8.80** 3 na
(-14.89) ()
Spain 13.92** 10 14.47** 10
(-8.91) (-7.43)
Sweden 18.68 19 18.57* 22
(-0.59) (-2.16)
Switzerland 13.24** 15 14.28** 15
(-4.50) (-4.07)
U.K. 25.84** 71 27.01** 79
(9.52) (8.96)
Average Rating 19.39 248 20.99 258
Note:
Table 2 presents the average rating of each country in 2000 and 2001, respectively. T-statistics are stated
in parentheses. The null hypothesis is that there is no signicant dierence between the country mean
and the sample mean.
** Signicant at the 1% level.
* Signicant at the 5% level.
19
Table 3: Performance Evaluation
R
mt
R
ft
SMB HML MOM
Style-corrected:
U.K. 6.83 0.25** -0.11 -0.10 -0.03
(1.32) (3.09) (-0.62) (-0.89) (-0.37)
EMU 1.58 -0.04 -0.40** 0.46** -0.15
(0.36) (-0.78) (-3.08) (-3.44) (-2.01)
Style and
Sector-corrected:
U.K. 4.63 -0.02 -0.15 0.19 -0.04
(1.16) (-0.37) (-1.21) (-1.49) (-0.30)
EMU 2.97 0.06 -0.22 0.04 -0.22*
(0.79) (1.35) (-1.88) (0.31) (-2.01)
Style and
Country-corrected:
EMU -1.04 -0.04 -0.12 0.59** -0.07
(-0.26) (-0.85) (-1.00) (4.47) (-0.97)
Note:
Table 3 shows the results of the performance evaluation regressions, equation (1), for the EMU and U.K.
sample respectively. Besides correcting for style exposures using the Carhart Model, we also adjusted for
sector- and country eects. T-statistics are stated in parentheses.
** Signicant at the 1% level.
* Signicant at the 5% level.
20
Table 4: Corporate Governance and Firm Value
Sector-adjusted Country-adjusted
EMU U.K. EMU
Year CG CG CG
1996 0.13 0.09 0.25
(0.89) (0.52) (1.44)
1997 0.17 -0.03 0.38*
(1.21) (-0.14) (2.25)
1998 0.14 0.23 0.05
(0.98) (1.03) (0.30)
1999 0.13 0.13 -0.17
(0.85) (0.44) (-0.77)
2000 0.10 -0.19 -0.06
(0.72) (-0.64) (-0.32)
2001 0.19 -0.15 0.16
(1.16) (-0.69) (1.00)
Mean 0.14** 0.01 0.10
(11.28) (0.18) (1.23)
Note:
Table 4 shows the results of equation (2) and equation (3). The results of equation (2) are displayed in
column 1 and 2 for the EMU and the U.K., respectively. Column 3 presents the results of equation (3)
for the EMU. The rst six rows display the annual coecients of Corporate Governance (CG). The last
row presents the time-series statistics. T-statistics are stated in parentheses.
** Signicant at the 1% level.
* Signicant at the 5% level.
21
Table 5: Corporate Governance and Firm Performance: European Monetary Union (EMU)
Net-Prot-Margin Return-on-Equity
Year CG CG
1996 -0.12 -0.08
(-1.12) (-0.96)
1997 -0.17 -0.08
(-1.61) (-0.90)
1998 -0.20* -0.05
(-2.01) (-0.55)
1999 -0.06 0.04
(-0.61) (-0.38)
2000 -0.10 -0.11
(-1.11) (-1.21)
2001 -0.03 -0.12
(-0.41) (-1.68)
Mean -0.14** -0.07*
(-4.44) (-2.94)
Note:
Table 5 shows the results of equation (4) and equation (5) for rms incorporated in the European
Monetary Union. The results of equation (4) are displayed in column 1. Column 2 presents the results of
equation (5). The rst six rows display the annual coecients of Corporate Governance (CG). The last
row presents the time-series statistics. T-statistics are stated in parentheses.
** Signicant at the 1% level.
* Signicant at the 5% level.
22
Table 6: Corporate Governance and Firm Performance: U.K.
Net-Prot-Margin Return-on-Equity
Year CG CG
1996 -0.83 0.02
(-0.55) (0.18)
1997 -0.75 -0.22
(-0.49) (-1.46)
1998 -0.61 0.08
(-0.38) (0.81)
1999 0.32 0.10
(0.20) (0.76)
2000 0.00 -0.06
(0.02) (-0.38)
2001 0.01 0.07
(0.04) (0.60)
Mean -0.31 -0.00
(-1.58) (-0.05)
Note:
Table 6 shows the results of equation (4) and equation (5) for the U.K. The results of equation (4) are
displayed in column 1. Column 2 presents the results of equation (5). The rst six rows display the annual
coecients of Corporate Governance (CG). The last row presents the time-series statistics. T-statistics
are stated in parentheses.
** Signicant at the 1% level.
* Signicant at the 5% level.
23
Table 7: Corporate Governance and Firm Performance: European Monetary Union
Regressions incl. Country Dummies
Net-Prot-Margin Return-on-Equity
Year CG CG
1996 -0.10 0.06
(-0.83) (0.68)
1997 -0.15 -0.08
(-1.22) (-0.82)
1998 -0.17 0.01
(-1.50) (0.13)
1999 -0.12 0.02
(-1.02) (0.21)
2000 -0.00 -0.12
(-0.01) (-1.10)
2001 -0.02 -0.04
(-0.22) (-0.46)
Mean -0.09* -0.02
(-3.33) (-0.88)
Note:
Table 7 shows the results of equation (6) and equation (7) for the EMU. The results of equation (6) are
displayed in column 1. Column 2 presents the results of equation (7). The rst six rows display the annual
coecients of Corporate Governance (CG). The last row presents the time-series statistics. T-statistics
are stated in parentheses.
** Signicant at the 1% level.
* Signicant at the 5% level.
24