New research shows that companies that engender high employee satisfaction are rewarded with higher stock prices and investor returns.
Many CEOs have stated that “employees are our greatest asset.” However, due to accounting rules requiring that most expenditures related to employees be treated as costs and expensed as incurred, the value of employees is an intangible asset that does not appear on any balance sheet. In his 2013 study, “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,” Alex Edmans analyzed the relationship between employee satisfaction and long-run stock returns. His hypothesis was that employees are key organizational assets, rather than expendable commodities, who can create substantial value by inventing new products or building client relationships, benefiting shareholders. This is especially true for modern knowledge-based industries, such as pharmaceuticals or software. In addition, high employee satisfaction can be a valuable recruitment tool.
Edmans began by noting that research had found that firms with high R&D, advertising, patent citations and software development costs had all earned superior long-run returns. He hypothesized that the market may be even more likely to undervalue employee satisfaction because theory has ambiguous predictions for whether it is desirable for firm value. His database was the list of the 100 best companies to work for in America (typically, 50 to 70 are publicly traded). The list was first published in a book in March 1984 and updated in February 1993. Since 1998 it has been featured in Fortune magazine each January. It is compiled from two principal sources. Two-thirds of the score comes from employee responses to a 57-question survey created by the Great Place to Work Institute in San Francisco covering topics such as attitudes toward management, job satisfaction, fairness and camaraderie. Two hundred fifty employees across all levels are randomly selected in each firm. The remaining one-third of the score comes from the Institute’s evaluation of factors such as a company’s demographic makeup, pay and benefits programs, and culture. The companies are scored in four areas: credibility (communication to employees), respect (opportunities and benefits), fairness (compensation, diversity) and pride/camaraderie (teamwork, philanthropy, celebrations).
Following is a summary of his findings:
- There is a strong, robust, positive correlation between satisfaction and shareholder returns – firms with high levels of employee satisfaction generate superior long-term returns even when controlling for industries or factor risk.
- A value-weighted portfolio of the 100 best companies to work for earned an annual four-factor alpha of 3.5% over the period 1984-2009, and 2.1% above industry benchmarks. The returns were slightly higher when equal weighted.
- The results were robust to controls for firm characteristics, different weighting methodologies and the removal of outliers.
- The best companies also exhibited significantly more positive earnings surprises and announcement returns.
- The market learns about the true value of employee satisfaction over time as it releases positive tangible news (positive earnings surprises) – the benefit of list inclusion declines over time and becomes insignificant in the fifth year.
- Buying stocks dropped from the best companies list or not updating the portfolio for future lists leads to lower returns than holding the most current list.
Interestingly, the results were slightly higher in the period after Fortune began publishing the results. That might be explained by the finding that employee satisfaction is not a permanent characteristic, and list updates contain useful information. In the Fortune subperiod, the list was updated every year, whereas for 1984-1997 it was updated only once in the 14-year period. Since the list has been public since 1998, it seems likely that factors other than the lack of information are behind the misvaluation of intangibles, such as the difficulty in incorporating intangibles into traditional valuation models.
His findings led Edmans to conclude that employee satisfaction is positively correlated with shareholder returns, the stock market does not fully value intangibles, and certain socially responsible investing (SRI) screens may improve investment returns. He also offered this explanation for the outperformance of the best companies to work for: “Investors use traditional valuation methodologies, devised for the 20th century firm and based on physical assets, which cannot incorporate intangibles easily.” He added that prior research had found that “strong governance earned abnormal returns while trading at a valuation premium at the start of the return window. The higher ratios suggest that the market is at least partially valuing the intangibles.”
Edmans’ findings are consistent with those of global index provider FTSE Russell, which found that an equally-weighted index of the publicly traded companies among the 100 best companies returned 11.7% annually from 1998 (when Fortune began publication of the list) through 2016, 5% more than the equivalent returns for both the Russell 3000 and Russell 1000 Indices.
Investor takeaway
The dramatic increase in demand for ESG (environmental, social and governance) investments has resulted in a lower cost of capital for firms with high ESG ratings. Thus, an important takeaway is that firms with high employee satisfaction are likely to receive high “S” scores and therefore have higher valuations, lowering their cost of capital and providing a competitive advantage. Other intangibles, like R&D and advertising, are not SRI/ESG screens. Finally, if the market has learned of the positive correlation between list inclusion and future returns, the returns should go down over time, and eventually excess returns should disappear.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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New research shows that companies that engender high employee satisfaction are rewarded with higher stock prices and investor returns.