Good risk management and shareholder value are strongly correlated, explains Ken Davey
Corporate governance has been on the lips of every shareholder, executive and financial pundit over the past 12 months. The Sarbanes-Oxley Act has provoked heated debate in the US about the role of auditors and boards, while in Britain Derek Higgs courted controversy with his review of the role of non-executive directors. Outside this regulation-driven debate, the concept of corporate transparency, enabling stakeholders to have a much clearer view of how well companies are being managed, is also growing in importance.
However, the role of basic, sound management of the physical risks facing companies has been far less topical. Now, a new study, Improving Risk Quality to Drive Value, shows for the first time that good risk management and shareholder value are strongly correlated. At a time when shareholder activism is rocketing, this is vital.
Oxford Metrica, the internationally-recognised strategic advisory firm, analysed the financial performance and risk quality of 438 publicly-quoted companies with a combined market capitalisation of £2.1trn. The study found that those companies with a high risk quality display low cash flow volatility, a key driver of shareholder value.
Dr Deborah Pretty, principal of Oxford Metrica, says: "These findings provide evidence for what is intuitively understood by corporate executives, but to date has not been demonstrated quantitatively: that risk quality is a key component of effective corporate governance and value management."
In order to undertake its ground-breaking study, Oxford Metrica required to measure both the risk quality and financial performance of each of the 438 sample companies. To ensure the sample was not skewed, its structure was tested against that of the world's largest 1000 companies by market capitalisation, and was found to be consistent.
My own company, FM Global, was able to supply Oxford Metrica with results from a well-developed risk measurement tool, its Risk Mark benchmarking system. The Risk Mark score has been developed over the past five years by the company's 1,400 strong engineering force, who visit over 130,000 locations annually. While originally based on individual locations, the corporate scores are found to correlate strongly with FM Global's actual property loss experience. By grouping the scores into quartiles we can clearly see that companies with an average risk mark in the 1st (highest) quartile contribute to less than 10% of the total losses incurred, as illustrated in Figure 1.
Risk Mark uses a 100-point scale to measure companies' risk quality, based on three major causes of physical damage: fire and explosion, natural hazard and occupancy. FM Global provided Oxford Metrica with the Risk Mark scores of each of the sample companies, which were placed into four groups, with those with the highest risk quality in quartile one and those with the lowest in quartile four.
Pretty was pleased to be able to find a robust measure of risk quality. She explains: "We've wanted to do this kind of study for a long time; the consistency in application of FM Global's risk engineering visits and the large sample size ensure that the results are as credible as practicably possible."
Next it was necessary to measure the shareholder value performance of the 438 sample companies. Pretty says that shareholder value is, in effect, investors' expectations of the company's future cash flow performance, based on the corporate and financial information made available to them. It can be defined as the present value of the future cash flow from operations. "By helping to protect these current flows, risk management achieves a multiplicative effect on shareholder value. Protecting one dollar of current cash flow translates into the protection of multiple dollars of value. In other words, by protecting cash flows, shareholder value is maintained and even increased."
For its study, Oxford Metrica measured shareholder value performance by taking into account several risk and return characteristics of the sample companies, including their average annual stock return and their average risk-adjusted stock return. The calculations were made for a five-year period, so no single year's performance had an undue influence on the results.
The results of both the risk and value measurements were then analysed. Oxford Metrica identified a strong and negative correlation between the companies' total Risk Mark score and both the variance in cash flow and the variance in earnings. Risk quality was directly linked with cash flow and earnings volatility. Figure 2 shows the correlation relationships between the corporate Risk Mark score and shareholder value.
"Best practice in risk management, displayed by the companies in quartile one, experiences less than half the cash flow volatility experienced by the companies in quartile four," says Pretty. "Investment in risk management that, over time, results in higher Risk Mark scores, represents an additional driver of the company's ability to generate reduced financial risk and improved cash flow performance. Together, these can create shareholder value."
Oxford Metrica also found that there was little use in a company concentrating on just one of the three core risks, say protection from natural hazards alone, because no single component was found to be responsible for the relationship between risk quality and shareholder value. Pretty suggests therefore that risk managers cannot pick and choose between the elements of risk quality in order to enhance value. "Credibility and integrity in the risk management culture across the firm are essential."
Previous research by Oxford Metrica, Reputation and Value - the case of corporate catastrophes, has clearly shown the effect a major disruption can have on shareholder value. This tracked firms who had a major reputation crisis to see if the crisis had an impact on the shareholder value of the company. It found that shareholder value was significantly affected by such events as product contamination, or a fire at a key plant. It also illustrated that the way the company handled the crisis had a profound impact on the company's value recovery.
One of the strengths of the Improving Risk Quality to Drive Value study is that it was not necessary to wait for a company to be hit by a major event in order to see if there was any effect on shareholder value. This means that those responsible for reducing risk can use the study to help justify a comprehensive risk management programme as a necessary part of maintaining the continuity of business operations and maintaining a stable cash flow.
The study should spark a more informed discussion about what constitutes corporate transparency and the returns shareholders may expect from a firm's investment in sound risk management. It can be downloaded at either www.fmglobal.com or www.oxfordmetrica.com
Ken Davey is managing director, international division, FM Global, Tel: 01753 750 000, E-mail: Kenneth.davey@fmglobal.com
