How business ethics can unlock shareholder value

How business ethics can unlock shareholder value

The situation: Which companies will provide shareholder value for the future? The answer is usually hazy, but it’s clear that investments in unethical firms earn abnormally negative returns over time.

The solution: Ethical behavior foretells performance in general, enhances productivity, and helps companies avoid trust- and equity-destroying scandal. “Superior human capital practices are not only correlated with financial returns. They are, in fact, a leading indicator of increased shareholder value,” say the consulting firm Watson Wyatt Worldwide, based on its own research.

Ethical behavior also lessens the risks from scandal. Like a smoke detector, an ethics program helps identify and halt misconduct before serious damage occurs. The risks include:

  • Criminal charges with the possibility of fines over $500 million and jail time for executives. If a firm has an ethics program, however, a judge can slash the fines by up to 95 percent.
  • Civil charges with the likelihood of large awards and permanent public taint.
  • Bankruptcy. Enron, WorldCom, and Adelphia are only the best known of the firms that went bankrupt morally before financially.

Signs that a company is on the right track

  • Look for an ethics code. Companies with an ethics code generate significantly more economic value added (EVA) and market value added (MVA), have less P/E volatility, and in one study showed a 50 percent increase in average return on capital employed.
  • Look for top-tier involvement. This would be a board-level ethics committee, an ethics management committee of senior executives, an ethics officer, and an ombudsperson. A firm may not need all of them, but they are indicators as to how seriously it treats ethics.
  • Look for participation in an outside ethics program. Read about Josephson Institute’s consulting and training programs here »
  • Expect transparency from ethical behavior. Transparent companies are more effective internally, reveal more to investors, and are less likely to yield unpleasant surprises. One indicator is inclusion in socially responsible funds (though overall their performance roughly equals that of other funds). “Socially responsible funds tend to have a growth bias,” says Russel Kinnel, Morningstar’s director of fund research, “so they look a little smarter in a growth market and a little dumber in a value market.”
  • Expect better brand equity from ethical behavior. And with that comes improved customer awareness and loyalty. Most people say their perception of a firm’s honesty directly affects their buying decision. In one notable case, Johnson & Johnson saved its Tylenol brand after a rash of poisonings by defying PR advice and being frank with the public.
  • Look for a common language of values, one that increases mutual understanding. One well-known language is the Six Pillars of Character: trustworthiness, respect, responsibility, fairness, caring, and citizenship.