Firm performance & effective mitigation of adverse business scenarios

Abstract

An important question for firm management and markets is whether superior capabilities to mitigate the impact of adverse business scenarios lead to higher firm valuation and performance. We address this question by identifying empirical hypotheses from a new channel of the shareholder value maximization theory of risk management and evaluate them by using a new broadly applicable methodology based on the insight that effective risk management practices (e.g., financial, operational, strategic hedging) and other “unclassified” activities should result in a “hedging profile” with a lesser frequency of “bad” business outcomes relative to “good” outcomes. We measure the hedging profile of 5105 firms across 53 industries from quarterly earnings-based return on assets reported in Compustat, and relate it to firm performance using panel regressions while controlling for critical firm characteristics including median earnings and fixed effects for firm, industry, and year. The estimation reveals a strong positive effect of the hedging profile on Tobin's Q, excess returns, and return on assets (with R-squares above 74%). The study's empirical and theoretical results show that firms that exhibit greater capability to mitigate downside business risk experience higher valuations consistent with a new mechanism for shareholder value maximization theory of hedging based on skewness in firm earnings-based returns.