4.2 Relationships and performance measures

The question whether independence influences the financial results of companies has been the subject of research for decades now. This is apparent from research by Dalton et al. (1998), who have conducted a meta-analysis of results from articles that investigate this relationship. The oldest article that they have included in their analysis is a study of Pfeffer (1972) that dates back to 1972. In his study, Molz (1988) even refers to a book of Vance (1955) from 1955 that addresses this relationship. Nowadays the relationship is still the subject of analysis (e.g. Duchin et al. (2010) and Tian and Twite (2011)). The results of research in this field are rather inconclusive, as will appear from this chapter. Bhagat and Black report that evidence for correlations between board independence and company performance is mixed and merely little and negative (1999: 942). Bhagat et al. state that no relationship at all has been found between board independence and financial performance, whether measured by accounting or market indicators (2008: 1814).

Figure 4-1: The relationships between board independence, board activity and performance (Hermalin and Weisbach 2003: 12).

According to Hermalin and Weisbach (2003: 11-12) empirical research – with the exception of case studies – in this field can broadly be categorised in three categories, which are depicted in Figure 4-1. The first category focuses on the relationship between board independence and its influence on the execution of board tasks or the activity of the board. Examples of these tasks are the removal of the CEO, activity on the take-over market, the remuneration of the executive directors and the adoption of poison pills. The second category is based on the implicit assumption that the execution of these certain board tasks influences the financial performance of the company. Better execution of tasks is expected to lead to higher financial performance of companies. However, the arrow between board activity and performance is not the subject of research, as this relationship is difficult – if not impossible – to measure by data analysis. Instead, this second category measures the direct impact of board independence on financial performance. This relationship is visualised by a dashed line in the figure to stress that board independence itself does not affect financial performance, but that the behaviour of or execution of tasks by these independent board members might affect financial performance. A third category investigates the effect of financial performance on board composition, of which board independence is an important part. This third relationship stresses the concerns about endogeneity, which is a problem in studies on the relationship between corporate governance and performance (Bhagat and Bolton 2008: 257-258). This endogeneity issue emphasises the question about the direction of the causality: does board independence affect financial performance or is the relationship the other way around?

The relationships in the figure can be expressed in formulas as well. The three following formulas represent these relationships (Hermalin and Weisbach 2003: 11):

Board activity is a function of board composition or board independence and control variables. Examples of control variables are company size, leverage, age of the company, number of block holders, etc. This board activity is assumed to have impact on performance, which can be derived from the second equation and from the arrow in Figure 4-1. In this equation control variables are included as well. The third equation addresses the endogeneity issue by stating that board composition is a function of performance and control variables. As mentioned above and as visualised in the figure by the dashed arrows, researchers directly measure the relationship between board independence and performance. In this respect, they integrate the first formula into the second:

This chapter shows that a majority of studies focus on the latter equation with a suggested direct influence of board independence on financial performance. The reason for this choice is pragmatic; data on board independence and financial performance is quite accessible, whereas for board activity the black box of the boardroom needs to be examined. The relationship between board independence and financial performance is the only relationship addressed in this chapter. Specific research on the relationship between board independence and board activity and the relationship between financial performance and board composition is not taken into consideration. However, some of the studies in this chapter pay attention to certain board tasks as well. In this case the relationship between board independence and certain board tasks is briefly touched upon.

Table 4-1: Overview of market-based and accounting-based performance measures. Based on Brealey et al. (2011: 734-746) and De Boer et al. (2011: 179-185).

The studies in this chapter use different types of performance measures. The greatest difference is the underlying source of the performance information: measures derived from market prices or information derived from accounting information. Market-based performance measures show how investors value the company and accounting-based performance measures show how efficiently the company is managed (Brealey et al. 2011: 740-741). Table 4-1 gives an overview of a number of market-based and accounting-based performance measures, which are used in the studies in this chapter. The market-to-book (MTB) ratio gives the ratio of the current value of the company and the value the shareholders have originally put in it. The MTB is calculated based on the ratio of the share price of the company and the book value per share of the company. Thus, a higher market-to-book ratio means that the value has increased. The same holds for Tobin’s Q, although this performance measure uses the value of all assets instead of the value of equity. The price earnings (P/E) ratio is an indication of the expectations of investors. If they are willing to pay a relatively high amount for a share relative to the earnings of that company – i.e. a high P/E ratio – they might expect growth in the future. The total shareholders’ return is the return an investor has made on an investment in that particular company.1

The profit margin ratio is an accounting-based performance measure that measures the ability of a company to generate income from sales. Return on assets (ROA) and return on equity (ROE) show the earnings that are generated with the total assets and total equity at work respectively. Since equity providers have nothing to do with tax and interests, the ROE calculations use net income instead of operating profit or earnings before interest and tax (EBIT). Sales to total assets ratio shows how hard the company’s assets are at work. A high sales to assets ratio might be an indication that the maximum capacity has almost been reached and that new investments are necessary to increase sales further.2