Internal Governance Characteristics, Time-Varying Agency Costs and Stock Prices

Abstract

We propose that the relationship between corporate governance and equity prices operates through two distinct channels. First, at the individual firm level, strong corporate governance lowers agency costs and increases equity prices. Second, agency costs are time-varying, as manager expropriation is negatively related to the expected return on investment. This being the case, firms with strong corporate governance should outperform those with weak governance in the long-run, and this difference should be more prominent when the price of risk is high. Consistent with our proposition, and after controlling for traditional risk factors, we use a long time-series of hand-collected data to show that firms with strong internal governance characteristics have superior operating performance and generate higher returns for shareholders. This outperformance is particularly pronounced during the global financial crisis, when expected return on investment is low. Our proposition that both micro- and macro-level factors affect the relationship between corporate governance and returns provides a new framework for considering the impact of agency costs on shareholder value.