This article has been written by Ahmad Bala Jibrin pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.

This article has been edited and published by Shashwat Kaushik.

Introduction

In the business world, where business entities are in competition with one another, it becomes essential for a business entity to be well aware of its position and to conduct continuous evaluation of its performance in order to identify the areas where it requires improvement for the purpose of reaching its desired goals and increasing the firm’s value. This is where governance comes into the picture for the proper regulation of firm affairs.

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Governance can be referred to as the set of rules, regulations, policies and strategies that are used to regulate the affairs of a system, an authority or a group of people. Governance, when applied to a company or corporate body, is known as corporate governance. Corporate governance is the system in which companies are directed and controlled; it is the major determining factor of firm valuation in the dynamic business world. Having an effective corporate governance practice in place ensures that the company operates efficiently and effectively, which contributes to long term sustainability and value creation for shareholders and also instills great confidence in the investor. This article will explore the background and origin of corporate governance, firm valuation and its methods of valuation, the relationship between corporate governance and firm valuation, and the influence of corporate governance on firm valuation. 

Meaning of corporate governance

The most famous definition of corporate governance was given in 1992 by Sir Adrian Cadbury in his Report on Financial Aspects of Corporate Governance in the United Kingdom, “Corporate governance is the system by which companies are directed and controlled”. In other words, corporate governance is defined as the set of rules, regulations, processes, ethical codes and organisational structures that regulate the conduct of stakeholders in the company or any corporate body. The responsibility of regulating the conduct of the stakeholders and managing the internal and external affairs of the company is usually placed upon the board of directors of the company. The role and responsibility of the board of directors are regulated by the constitutional documents of the company, specifically the article of association, which is also known as the bye laws. Shareholders play the crucial role of appointing the members of the board of directors, which is considered to be an important contribution to the corporate governance of a company. The board of directors of a company is the primary force influencing corporate governance.

Corporate governance is mostly about what the board of directors of the company does and how it sets the values of the company. Having the right fundamental values such as transparency, accountability, fairness, and responsibility in place helps a company build strong and sustainable confidence in investors, stakeholders, and society at large.

In addition to that, effective corporate governance ensures that companies have the appropriate decision-making processes and control. Corporate governance is fundamentally concerned with the balance of stakeholder interests, including shareholders, directors, employees, customers, suppliers and governments.  Corporate governance is an important aspect because it helps companies achieve their goals, control risks, and assist with formal decision-making in order to avoid risks.

Origin of corporate governance

Corporate governance can be said to be a fairly recent issue; however, the concept has been in existence since the corporation itself. The United States of America is the country where corporate governance originated. Back in the 1970’s, the term “corporate governance” was added for the first time to the official journal of the federal government called the Federal Register in 1976. The idea of regulating the affairs of the company has been developed since the 1920’s, after a high number of well performing United States companies went bankrupt, which led to economic crises that happened due to the stock market crash. 

In order to prevent further damage, the United States government passed two legislations. The two legislations are the Security Act of 1933 and the Security Exchange Act of 1934. Both the legislations provided governance procedures for transactions of security for the company. The Security Exchange Act, 1934, led to the establishment of the Security Exchange Commission (SEC). The SEC is a regulatory body that performs the function of enforcing federal security laws and regulating the security industry, which includes the nation’s stock and option exchange. The primary objectives of the SEC are enforcing securities laws, facilitating capital formation, protecting investors, and maintaining fair, orderly and efficient markets. 

In the early 1990’s, the concept of corporate governance became a point of discussion in the United Kingdom. Many executives of companies were engaged in unfair practices, which led to various issues. The London Stock Exchange and Financial Reporting Council formed a committee in 1991 to address financial aspects of corporate governance. This committee is known as the Cadbury Committee. 

The Cadbury committee, led by Sir Adrian Cadbury, provided a report and suggested adapting major principles such as accountability and responsibility of directors, disclosure of information to the right authority, equitable distribution of shares with respect to the shareholders, e.t.c., and also made a code that was added to the London Stock Exchange list for companies. 

Corporate governance in India

The concept of corporate governance in India can be traced back to the pre-independence period, when India was under the colonial rule of the British. The colonial rulers introduced corporate structures such as joint-stock companies. The governance practices during that period were primarily influenced by British legal frameworks and lacked indigenous governance principles. After India’s independence in 1947, it embarked on a journey of economic development. The government of India played a dominant role in economic growth by creating multiple state-owned enterprises. However, corporate governance during that period was in place for both public owned and state owned enterprises under government supervision with limited regulatory control.

In 1999, the Ministry of Corporate Affairs and the Stock Exchange Board of India (SEBI) worked together to bring principles of high value to corporate governance. The two government bodies formed the Kumar Mangalam Committee under the leadership of Mr. Kumar Mangalam, who was the then chairman of SEBI. The committee was established to address the increasing concerns relating to corporate governance practices in India. The committee, in its report, stated a comprehensive set of recommendations aimed at strengthening corporate standards in India by enhancing transparency, accountability and integrity in the functioning of the companies. The committee also aimed to form an audit and appoint independent directors and supervisors for the management of the internal affairs of the company. 

Meaning of firm valuation 

Firm valuation can be simply defined as the process of determining the economic value of a company or a corporate entity. The process involves assessing the total worth of the company based on some important factors that are related to the company, such as its total assets, position in the market, growth potential and financial standard. Firm value is an important aspect that stakeholders in a company must pay attention to because the value of the company is a reflection of the economic and financial condition of the company. It is the determining factor as to whether or not the company is in good financial condition and whether the company can generate a good profit for the shareholders.

In addition to that, a firm valuation report is more than just mere figures and words; it is a powerful asset that gives an insight into the internal affairs of the company. In a situation where the firm’s value is high, potential investors would be able to trust the company and would not hesitate to invest their capital in it. 

Methods of firm valuation

In order to accurately evaluate a firm or company, one must possess good knowledge of the different approaches and methods of valuation as well as industry specific knowledge. However, it is possible for regular individuals to become acquainted with the fundamental approach used by valuation experts in some cases to make basic estimates of the company’s or firm’s value through simple calculations.

There are three basic approaches on which most valuation methods are based; these approaches include the income-based approach, the market-based approach and Assets- based approach. 

Income-based approach

An income-based approach is an approach that is used to estimate the value of a company or firm based on the anticipated future income generating potential of the company or firm.

Market-based approach

A market-based approach is an approach that is used to estimate the value of a company or firm by comparing that particular company to similar publicly traded companies or firms.

Assets-based approach

The asset-based approach is another approach that is used to determine the value of a company or firm by way of subtracting its liabilities from its total assets. 

The most common methods of firm valuation are Discounted Cash Flow (DCF) Analysis, Comparable Company Analysis (CCA) and Book Value Analysis (BVA). Each of these methods has its own strengths, weakness and applicability, depending on company specific industry and valuation required.

Discounted Cash Flow (DCF) Analysis 

Discounted cash flow is widely recognised, and it is a valuation method that is used to determine the present value of a firm’s future cash flow by discounting them back to the present value using the discount rate. DCF analysis requires the prediction of future cash flows, which can be challenging. It also requires assumptions about the discount rate, terminal value, and other necessary factors. The DCF process typically involves the following steps:

  1. Projecting future cash flows:
    • Estimating the firm’s future cash flows over a specified time horizon, usually several years.
    • These cash flows include operating cash flows, capital expenditures, and any other relevant cash inflows and outflows.
  2. Selecting the discount rate:
    • Determining the appropriate discount rate, typically the WACC, based on the firm’s specific circumstances and industry.
  3. Discounting future cash flows:
    • Applying the discount rate to each projected future cash flow to calculate its present value.
  4. Summing the present values:
    • Adding up the present values of all future cash flows will arrive at the total present value of the firm or asset.

DCF is widely used for various purposes, including business valuations, investment decisions, project appraisals, and mergers and acquisitions. It provides a quantitative framework for assessing the value of a company or project based on its expected future cash flows and risk.

However, it’s important to note that DCF is not without limitations. The accuracy of the valuation depends heavily on the reliability and accuracy of the projected cash flows and the chosen discount rate. Additionally, DCF does not consider factors like qualitative aspects, market sentiment, or competitive dynamics, which can also influence a firm’s value.

Comparable Company Analysis (CCA)

As the name suggests, Comparable Company Analysis is a valuation method that involves comparing the financial metrics of a particular company or firm with those of similar publicly traded companies in the same industry. This method is commonly used by private companies; it is a method that helps in determining whether the company or firm has the anticipated value compared to the company in the same industry. The process of CCA typically begins with identifying a set of comparable companies. These companies should be similar to the subject company in terms of industry, size, growth stage, and financial profile. Once the comparable companies have been identified, the next step is to gather financial data for each company. This data can be obtained from publicly available sources such as company websites, SEC filings, and financial databases.

The financial data that is typically used in CCA includes revenue, earnings, cash flow, and debt. Once the financial data has been gathered, the next step is to calculate the relevant multiples and ratios. These multiples and ratios can then be used to compare the subject company to its peers.

Some of the most common multiples and ratios used in CCA include:

  • Price-to-earnings (P/E) ratio
  • Price-to-sales (P/S) ratio
  • Price-to-book (P/B) ratio
  • Enterprise value-to-revenue (EV/R) ratio
  • Enterprise value-to-EBITDA (EV/EBITDA) ratio

By comparing the subject company’s multiples and ratios to those of its peers, analysts can gain insights into the company’s relative valuation. If the subject company’s multiples are higher than those of its peers, this may indicate that the company is overvalued. Conversely, if the subject company’s multiples are lower than those of its peers, this may indicate that the company is undervalued.

Book value method

The book value method is a valuation method that determines the value of a company or firm by subtracting the total liabilities of the company from its total assets as recorded in the books of the company. This is a method that provides a simple measure of the total value of a company; however, it is quite impossible to get an accurate value, particularly with respect to intangible assets. 

Relationship between corporate governance and firm value 

The relationship between corporate governance and firm value is heavily influenced by the board of directors of the company. The board of directors is the key to the well-functioning of corporate governance practices in the company. The practices and conduct of the board of directors, which are mandated by corporate governance principles, ensure accountability, fairness and transparency in the company’s relationship with stakeholders. The monitoring role of the board of directors is an important component of corporate governance and that results in a significant positive impact on the overall performance of the company.

In a company, corporate governance deals with mechanisms through which the stakeholders exercise control over the management of the internal and external affairs of the company such that their interests are protected. Stakeholders in this context include shareholders, investors, employees, consumers, suppliers, the government and society at large. Having an effective corporate government system in place enhances investor confidence, enables the company to achieve its long term objectives and ultimately increases its value. 

Influence of corporate governance on firm valuation

There are several factors in the realm of corporate governance that influence the firm’s valuation and performance.

Board composition

Board composition involves the size and structure of the board. When composing a board, it is important to consider diversity in experience, skills and backgrounds. A board composed of a diversity of thoughts tends to build good rapport, share valuable ideas while dealing with issues and make better decisions.  The composition of the board tends to have an influence on board independence; the more independent a board is, the more effective it becomes and that improves the performance of the company.

Presence of independence directors

An independent director is a member of the board who does not hold any stake in the company and does not represent any shareholder. According to the Cadbury Report 1992, independent directors protect the shareholders interests by playing their role as independent and impartial members of the board.  The independent directors act as mediators in the event that conflict arises between shareholders and executives. The presence of independent directors improves the standard and performance of the company, as independent directors have no private interest and are also free from board influence; therefore, this enables the independent directors to provide efficient and high quality monitoring.

Board meetings

A board meeting is any official meeting of the directors of a company. Board meetings are the meetings at the highest level. Board activities are usually presented during the board meetings in order to enhance the monitoring activity and also reflect on the performance of the company. Frequent board meetings have a positive impact on the performance of the company, high frequency of board meetings improves the overall performance of the company through continuous monitoring, which helps resolve issues more quickly.

Board committee

The board committee is subordinate to the board of directors and is usually comprised of a small subsection of the board of directors. Having an effective board committee is an integral part of good corporate governance. An effective board committee plays a crucial role in enabling the board to achieve greater efficiency in the activities of the company and also increase its value. Basically, a board committee is tasked with specialised operations by the board or provides expert advice or reports to the board.

Conclusion

Corporate governance has a deep impact on the overall aspects of a company. The existence of good corporate governance practices in a company ensures transparency, accountability, fairness and also protects the interests of the stakeholders of the particular company. In turn, by promoting and upholding effective corporate governance practices, a company can widen its awareness of its day to day operations, enhance its decision making ability, increase profitability, comply with all legal requirements, improve financial stability, reduce risks and ultimately increase the value of the company on a large scale in the capital market. 

On the other hand, poor corporate governance practices may lead to undesirable outcomes such as poor stakeholder relations, ineffective internal control, conflict of interest, inadequate risk management, a weak board of directors and a lack of transparency and accountability. Therefore, it is necessary for any company willing to grow to ensure efficient corporate governance practices and conduct in order to grow and improve its operations and ultimately increase the value of the company.

References

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