Is Corporate Sustainability a Value-Increasing Strategy for Business?

IS CORPORATE SUSTAINABILITY A VALUE-INCREASING STRATEGY FOR BUSINESS?

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Blackwell Publishing LtdOxford, UK CORGCorporate Governance: An International Review0964-8410© 2007 The Authors; Journal compilation © 2007 Blackwell Publishing Ltd March 2007152345358ORIGINAL ARTICLESIS CORPORATE SUSTAINABILITY A VALUE-INCREASING STRATEGY FOR BUSINESS?COPRORATE GOVERNANCE

Is Corporate Sustainability a ValueIncreasing Strategy for Business? Shih-Fang Lo* and Her-Jiun Sheu A new movement reconciling corporate sustainability and investment is gaining world-wide attention. Whether corporate sustainability has an impact on market value is examined using large US non-financial firms from 1999 to 2002 in this paper. Taking Tobin’s q as the proxy for firm value, a significantly positive relation between corporate sustainability and its market value is found. We also find a strong interaction effect between corporate sustainability and sales growth on firm value. Moreover, there is evidence to support that being sustainable causes a firm to increase its value. This indicates that companies with remarkable sustainable development strategies are more likely to be rewarded by investors with a higher valuation in the financial markets. Keywords: Corporate social responsibility, corporate governance, sustainability index, market value, Tobin’s q, panel data

Introduction efore The Wealth of Nations, Adam Smith wrote The Theory of the Moral Sentiments (1759), which states that a capitalist system must be based on honesty and integrity, otherwise it will be destroyed. Adam Smith understood that self-interest should be moderated by ethics so that purely selfish or exploitative behaviour would be the exception and not the rule (Dawson, 2004) in our society. The corporation has to honour the moral minimum or respect individual rights and justice while making a profit (Bowie, 1995). Following the business scandals and corporate failures which occurred in the past few years, works to rebuild public trust in business and in the financial markets have been discussed extensively both in practice and academia. Many current studies in corporate governance have focused on those issues, including corporate fraud, the abuse of managerial power and business social irresponsibility, etc. In response to the changing market, business is being forced to take externalities into account in management behaviour. Corporate social responsibility and ethics are thus becoming a vital part of staying competitive, partly

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because they help to retain talented staff and to satisfy customers’ expectations (Gardiner et al., 2003). Different from the previous research regarding corporate responsibility and ethics, the authors of this article would like to introduce a less touched upon topic – “corporate sustainability” – a positive multi-faceted concept covering areas of environmental protection, social equity, community friendship and sustainable development in corporate governance and to test its impact on a firm’s market value. “Corporate sustainability”, by definition, is a business approach that creates long-term shareholder value by embracing opportunities and managing risk from economic, environmental and social dimensions (Dow Jones Sustainability Indexes). Aside from creating profit, sustainable company leaders capture other qualitative, non-financial criterion as references for their performance, such as quality of management, corporate governance structures, reputation, human capital management, stakeholder relations, environmental protection and corporate social responsibility. Contrary to traditional business belief which aims to make a profit without taking into consideration the social and environmental

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*Address for correspondence: International Division, ChungHua Institution for Economic Research, Taiwan, R.O.C. Mailing Address: Rm 516, 75 Chang-Hsing St, Taipei 106, Taiwan, R.O.C. Tel: +886-22735-6006, ext. 516; Fax: +8862-2739-0610; E-mail: shihfang. [email protected]

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consequences, a new style of investment is getting more and more attention and is gaining world-wide momentum: the so-called ethical investment. As a new movement that reconciles corporate responsibility (social and environmental responsibilities) and investment is emerging, it is worth asking whether corporate sustainability is a value-increasing strategy for today’s companies. Both academia and those practising corporate sustainability are starting to discuss the benefits derived from a firm’s sustainability performance. However, the influences have only a few empirical foundations, especially from the standpoint of an investor. In this article, we examine whether or not corporate sustainability has an impact on firm value using a sample of large US non-financial firms from 1999 to 2002. It is therefore a study investigating the effect of membership of the DJSGI USA on firm value. Data and information on this topic are typically well represented in the US, and thus this paper tends to focus on the US trends, even though similar cases can be found in Europe and other regions. Tobin’s q is taken as the proxy for firm value. It is found that a positive relation exists between a firm’s value and corporate sustainability. The sustainable premium is statistically significant. Those companies actively maintaining sustainable development are more likely to be rewarded by investors, because of having a higher valuation in the financial market. The paper herein extends prior studies and contributes in the following ways. From the theoretical perspective, it initiates by bringing together the concepts of corporate sustainability and financial performance into two contrasting paradigms: the shareholders’ perspective and stakeholders’ perspective. From the empirical perspective, we use panel data to control for any unobservable firm heterogeneity to test our hypothesis. Hill and Snell (1989) prefer using panel data to crosssectional analysis while using static data to test dynamic relationships. We estimate both the pooled and fixed-effects models. Possible interaction between corporate sustainability and other financial variables on a firm’s value are explored. Lagged independent variables are used to ensure that our results are not affected by endogenous regressors.

Theoretical background This section contains three aspects of pertinent literature: the concepts and definitions of corporate responsibility versus corporate sustainability, the relationship between corporate governance and ethical investing, and the

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linkage between corporate sustainability and firm market value are reviewed herein to provide a theoretical background to this study.

Corporate responsibility versus corporate sustainability Recent corporate scandals have emphasised the need for greater transparency and accountability. A more humane, ethical and transparent way of doing business is therefore broadly discussed. However, related concepts such as corporate social responsibility, sustainable development, business ethics and their sister concepts are still too ambiguous in academic debate or in corporate implementation (Votaw and Sethi, 1973; De George, 1990; Henderson, 2001). These concepts are often used to fit various management purposes (e.g. total quality management, marketing, communication, finance, human resources management, etc.) and still lack standard definitions (van Marrewijk, 2003). Take the term “corporate social responsibility” for example. A classical view from the shareholder approach is that the social responsibility of a business is to increase its profits and value for its owner (Friedman, 1962; Quazi and O’Brien, 2000). The stakeholder approach points out that business is not only accountable to its shareholders, but should also consider stakeholder interests which may affect or may be affected by the operations or objectives of a business (Freeman, 1984; Evan and Freeman, 1988; O’Rourke, 2003). Corporate social responsibility can also be viewed from an instrumentalist perspective where corporate image and goals are of primary concern (MacAdam and Leonard, 2003). Yet the word “sustainability” remains ambiguous. In the past, while corporate responsibility refers to social aspects such as human rights, sustainability is usually related to the environment (Funk, 2003). In spite of the traditional bias of corporate sustainability towards environmental policies, there is sufficient interest in integrating social and economic aspects into corporate sustainability. “Corporate sustainability” is generally defined as a business approach that creates longterm shareholder value by embracing opportunities and managing risk from three dimensions: economic, environmental and social dimensions (Dow Jones Sustainability Indexes). A sustainable company is one whose characteristics and actions are designed to lead to a “sustainable future state” (Funk, 2003). In summary, corporate sustainability (CS) and corporate social responsibility (CSR) are referred to as voluntary business activities, including social and environmental concerns,

© 2007 The Authors Journal compilation © Blackwell Publishing Ltd. 2007


so as to interact with stakeholders. Some would argue of the “vagueness” between CS and CSR, but recently there are more and more studies trying to clear the lines between these two concepts. Wempe and Kaptein (2002) indicate that CS is the ultimate goal, with CSR as an intermediate stage where companies try to balance the Triple Bottom Line (profit, people and planet). Van Marrewijk (2003) recommends a distinction between CS and CSR. While CSR is “communication”-oriented relating to people and organisations (e.g. stakeholder dialogue, sustainability reporting, etc.), CS is concerned with the agency principle (e.g. value creation, environmental management, human capital management, etc.). Linnanen and Panapanaan (2002) depict the relationship between corporate sustainability and corporate responsibility by drawing a more consistent picture. Three aspects of corporate responsibilities (economic responsibility, social responsibility, environment responsibility) are contained in the realm of corporate sustainability that a business has to be concerned with. It is therefore showing how corporate social responsibility fits into the current corporate sustainability/responsibility framework.

Ethical investment and corporate governance “Ethical investment” began appearing in the late twentieth century and is an investing vehicle which reflects investors’ values and concerns regarding the impact and conduct of business activities (Williams, 1999; Gardiner et al., 2003). It selects companies for investment considering the social and environmental performances as well as the financial performance. The term “social responsibility investment” (SRI) is often used interchangeably with the term “ethical investment” (Mallin, 2002). Etzioni (1988) states that some investors are guided by a sense of moral duty. Therefore, investors who are not only interested in the maximisation of shareholders’ wealth but also the maximisation of stakeholders’ welfare will seek out those companies for an above average growth rather than a temporary outsized performance. Following Cassidy’s (2003) argument, it is believed that a substitution of longer-term sustainability for shorter-term volatility and risk is needed for today’s businesses. Leading sustainable firms are more likely to deliver predictable earnings with less negative concerns. In other words, corporate governance and the firm’s economic, social and environmental performance can be effectively linked with adequate disclosure (Ethical Corporation, 2003).


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Why are ethics and integrity important in corporate governance? “Corporate governance”, defined by Letza et al. (2004), is about the understanding and institutional arrangements for relationships among various economic actors and corporate participants who may have direct or indirect interest in a corporation, such as shareholders, directors/ managers, employees, creditors, suppliers, customers, local communities, government and the general public. On the other hand, corporate governance should not depart from ownership rights, but such rights should not be solely centred on shareholders; ownership rights can also be claimed by other stakeholders (Turnbull, 1994, 1997a, 1998; Letza et al., 2004). The Ethics Resource Center (2003) sees ethics as a core concept in corporate governance and the struggle against corruption. Companies perceived to be ethical can recruit and retain the best workers and foster positive, long-term relationships with vendors, customers, investors and stockholders (Potts and Matuszewski, 2004). Without high standards of corporate governance, businesses may under-perform, while those companies exercising strong governance on a habitual system based on ethical values will perform strongly (Cassidy, 2003). Therefore, ethics in business is not only a moral issue, but also instrumental in achieving better community relations (Moir, 2001). Ethical investment has now been increasingly perceived as a mainstream element of good corporate governance, both from individual companies and of institutional investors (Mallin, 2002), and good corporate governance can have good effects on long-term corporate financial performance (Allen, 2001). There is rapidly increasing interest in the area of sustainability and ethical investments both in the US and UK financial markets. The growth rate is up to 70 per cent per year in Europe and North America. Ethicallyscreened funds in the UK are in the range between £50 billion to £100 billion, while socially-screened funds are estimated to be US$2 trillion (Knoepfel, 2001). Moreover, global indexes, such as FTSE4Good Index and Dow Jones Sustainability Group Indexes, are designed to measure the performance of companies that meet globally-recognised corporate responsibility standards and to facilitate investment in those companies. The Dow Jones Sustainability Group Indexes (DJSGI) launched in 1999 are the first global indexes to track the financial performance of leading sustainability-driven companies worldwide. In a yearly review, 10 per cent of the leading sustainability companies

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in each of the ten economic sectors (consumer non-cyclical, consumer cyclical, energy, healthcare, financial, telecommunication, basic materials, technology, industrial and utilities) are selected from Dow Jones Global Index (DJGI) which includes 2000 global companies. The DJSGI is a family of 20 different indexes, and five of these indexes are geographical in character: the world as a whole, Europe, North America, the Asia-Pacific region, and the US. The companies included are continuously monitored throughout the year, and if necessary, excluded from the index. The identification of sustainability companies for DJSGI is based on the Corporate Sustainability Assessment of Sustainable Asset Management (SAM) Research. A defined set of criteria and weightings is used to assess the opportunities and risks in economic, environmental and social developments for the eligible companies as shown in Table 1. Those companies included in the DJSGI benefit from the growing demand for sustainability-related investments. In addition, they gain the reputation of being an industry leader in strategic areas covering economic, environmental and social dimensions.

Linking corporate sustainability to firm value Will a firm become unprofitable by adopting high ethical standards while its competitors adopt lower ones? The analysis of Brickley et al. (2002) points out that this is incorrect, since potential customers discount their demand prices where there is uncertainty about the quality of the product. Furthermore, by creditably promising to act ethically, a firm can differentiate its products and increase their demand. On the other hand, a firm that acquires a reputation for unethical behaviour will lose current as well as potential future customers and the profits they would have generated. Chami et al. (2002) argue that the corporation should care about ethics, because the firm’s ethical reputation is the valuable intangible asset which will affect the market price of its shares. The investors will aggregate their judgements and transmit them to the firm in the form of financial rewards or punishments. In summary, a firm’s value maximisation requires a deeper understanding of ethical standards than the typical economics discussion of short-run profit maximisation might suggest (Brickley et al., 2002).

Table 1: DJSGI corporate sustainability assessment criteria Dimension Economic (33% weight)

Environment (33% weight)

Social (33% weight)

Criteria Codes of Conduct/Compliance/Corruption & Bribery Corporate governance Customer relationship management Financial robustness Investor relations Risk & crisis management Scorecards/measurement systems Strategic planning Industry specific criteria Environmental policy/management Environmental performance Environmental reporting Industry specific criteria Corporate citizenship/philanthropy Stakeholders engagement Labour practice indicators Human capital development Knowledge management/organisational learning Social reporting Talent attraction & retention Standards for Suppliers Industry specific criteria

Information in this table is from Dow Jones Sustainability Indexes website (http://www.sustainabilityindexes.com)

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The demands from stakeholder groups for greater accountability of corporations on issues such as labour standards, environmental protection and human rights, if successfully implemented, are unlikely to negatively impact financial performance and may deliver financial gains (McLaren, 2004). To reverse traditional views that environmental compliances and social welfare expenditures are costly and correlate negatively with returns, Reinhardt (1999) suggests that there are opportunities for competitive advantage and increased profits by engaging in environment strategies. Many empirical studies have uncovered the positive relationship between corporate responsibility and its financial benefit, primarily on a firm’s environmental performance (Diltz, 1995; Konar and Cohen, 1997, 2001; Khanna and Damon, 1999; Blank and Carty, 2005). There is no doubt that financial reports can tell managers a great deal about past performance, but they are unable to reveal fully a company’s intangible assets or the risks and opportunities it faces in the market. Those intangibles related to environmental or social responsibility are highly interacted with customer satisfaction and other stakeholder preferences, and improvement in these areas can induce gains financially. Companies that actively manage a wide range of sustainability indicators are better able to create long-term value for all stakeholders (Funk, 2003). However, while there are numerous studies discussing the importance of ethics or sustainability to business performance, to date there is relatively little empirical evidence of whether or not a firm’s integrated responsible performance, such as its sustainable strategies covering economic, environmental and social dimensions, increases its value. That is the main subject which this study intends to discuss.

Estimation methodology Data This study examines whether or not corporate sustainability has an impact on firm value using a sample of US large non-financial firms

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from 1999 to 2002. With a ratio of one-fifth each year, the US companies consist of the largest part within the DJSGI component firms worldwide. Given that using the entire population in the DJSGI, which includes a set of global firms, is prohibitively costly and that selecting the counterpart firms (other nonsustainable firms) lacks generally-accepted principles, we therefore base our sample on large US firms. All non-financial firms of S&P 500 companies from the Compustat database are included. During the sample period, all the firms (sustainable firms and other nonsustainable firms) included are also listed in the DJGI USA. Firms of small and medium capital which are in the DJSGI USA but not in the S&P 500 are excluded. Table 2 presents the number and percentage of sustainable firms selected from DJSGI USA. Our sample consists of more than 60 per cent of the sustainable firms from DJSGI USA after eliminating financial and small–medium-sized companies. After removing observations with missing data, we are left with an unbalanced panel set of 1,273 data points for 349 firms during the years 1999 to 2002. Panel A of Table 3 reports the summary statistics of all firms. Panels B and C in the same table present the statistics of sustainable and other firms, respectively. We observe that the mean q for sustainable firms is 2.55 higher than the mean q of 1.66 for others. This primary result is consistent with our expectation that sustainable firms have a larger value than others. Aside from the mean q, most other control variables, such as mean size, dividend, debt to equity ratio, ROA, diversification and credit rating of sustainable firms, are higher than that of other firms. The mean value of q is higher than the median value of q from panel A to panel C, which suggests that the distribution of q is skewed. To control for the skewness, we take a natural logarithm of q as the dependent variable in our following analysis so that the distribution of q becomes more symmetric.

Empirical model Panel data require special statistical methods, because the set of observations on one

Table 2: Profile of sustainable firms

Numbers of firms in the DJSGI USA index Numbers of firms in the sample Per cent

1999

2000

2001

2002

Total

46 30 65%

52 33 63%

75 45 60%

61 40 66%

234 148 63%

This table presents the number and percentage of sustainable firms selected from DJSGI USA after eliminating financial and small–medium-sized companies in this paper.


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Table 3: Summary statistics Variable Panel A: All firms Tobin’s q Size (log of total assets) Dividend dummy Debt to equity ratio ROA Sales growth Investment growth Diversification dummy Credit rating Panel B: Sustainable firms Tobin’s q Size (log of total assets) Dividend dummy Debt to equity ratio ROA Sales growth Investment growth Diversification dummy Credit rating Panel C: Other firms Tobin’s q Size (log of total assets) Dividend dummy Debt to equity ratio ROA Sales growth Investment growth Diversification dummy Credit rating

Mean

Std. dev.

Median

Skewness

Kurtosis

1.77 8.99 0.78 0.87 0.05 0.12 0.09 0.78 4.46

1.77 1.08 0.42 1.81 0.09 0.42 0.12 0.42 0.94

1.20 8.99 1.00 0.67 0.05 0.06 0.05 1.00 4.00

4.01 0.20 −1.34 3.39 −2.94 7.39 4.87 −1.34 −0.08

26.01 −0.41 −0.23 255.70 23.37 91.17 35.57 −0.20 0.80

2.55 9.47 0.79 0.90 0.06 0.08 0.07 0.82 4.95

2.71 0.95 0.41 1.37 0.11 0.24 0.05 0.38 0.95

1.64 9.56 1.00 0.67 0.06 0.05 0.06 1.00 5.00

3.65 −0.60 −1.44 9.18 −4.48 1.57 1.94 −1.72 0.16

19.84 0.11 0.08 97.20 37.25 6.53 4.73 0.98 0.27

1.66 8.92 0.78 0.86 0.05 0.13 0.09 0.77 4.40

1.58 1.08 0.42 1.86 0.08 0.44 0.13 0.42 0.92

1.16 8.89 1.00 0.68 0.05 0.06 0.05 1.00 4.00

3.53 0.32 −1.32 9.44 −2.47 7.20 4.69 −1.30 −0.10

19.35 −0.28 −0.26 255.62 18.96 86.91 32.55 −0.31 0.86

This table presents summary statistics for our sample of all non-financial firms listed in S&P 500 index (panel A) and for the sub-sample for sustainable firms listed in DJSGI USA index (panel B) and the rest of other firms (panel C) from 1999 to 2002. Firm size is the logarithm of total assets. Dividend dummy equals 1 if the firm paid a dividend in the current year. Debt to equity ratio is taken as total liabilities over total equity. Return on assets (ROA) is defined as the ratio of net income (loss) to total assets. One-year sales change (percentage) is used to measure a firm’s sales growth. Investment growth is measured by the ratio of capital expenditure to sales. Diversification dummy equals 1 if the firm operates in more than one segment. Credit rating is established by a seven-scaled variable to specify the general credit rating of the firm. Follow Chung and Pruitt’s (1994) approximating formulation of Tobin’s q, the approximate q is defined as the sum of market value, preferred stocks, and debt over total assets. Market value is the product of a firm’s share price and the number of common stock shares outstanding; preferred stock is the liquidating value of the firm’s outstanding preferred stock; debt is the value of the firm’s short-term liabilities net of its short-term assets, plus the book value of its long-term debt.

subject tend to be inter-correlated. To control for firm-specific heterogeneity (such as corporate culture or managerial quality) which is not possible to measure but has a significant impact on firm value, a longitudinal model is employed. To account for unobserved heterogeneity in our data, we

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incorporate problems relating to the estimation of both fixed effects and random effects. Since unbalanced panel data is allowed in this model, the number of periods for each firm does not have to be the same. In this study we have panel data for t years for i



firms. The model can be estimated using a pool object written as: qit = a i + b 1¢Sit + β ¢Cit + eit ,

(1)

where αi is a scalar constant representing the effects of omitted variables that are specific to the ith firm and constant over time (Hsiao, 1986). Firm value is given by qit, Sit is the sustainability dummy that equals 1 if a firm is sustainable and 0 otherwise, Cit shows the various control variables that are included by the previous literature (i.e. firm size, ability to access financial markets, leverage, profitability, sales growth, investment growth, industrial diversification, credit quality and industry effects), b 1′ and b ′ are the panel regression coefficients, and εit is the error term which is assumed to be an independent and identical distributed random variable with mean zero and constant variance s e2. As the variance of the composite error term αi + εit is unknown, a feasible generalised least square method is used. If the firm-specific effects are correlated with the explanatory variables, then a fixed-effects model treating αi as a fixed constant is appropriate; if αi is uncorrelated with explanatory variables, then a random effects model is appropriate. Both models are used to test the stated hypothesis regarding corporate sustainability and firm value. The Hausman test is used to select the appropriate specification between these two models. The possible effects of reverse causality from firm value to sustainable dummy can be avoided since the dependent value of q is computed from the information at the end of the year and the independent variable of sustainable dummy takes a value prior to the end of the year. Once a company is selected as a member of the DJSGI family, it is monitored continuously with regard to newly arising critical issues (Dow Jones Sustainability Index), and any addition or deletion of components is regularly announced every September. It can therefore be ensured that our “cause” (being sustainable or not) precedes the “consequence” (firm value). Furthermore, in order to minimise the potential simultaneity bias caused by contemporaneous cross-sectional analysis, we lagged all our independent variables by one period. This approach of lagging the endogenous variables (i.e. firm size, ability to access financial markets, leverage, profitability, sales growth, investment growth, industrial diversification, credit quality) as explanatory variables is commonly used in longitudinal studies (Greene, 2003).


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Variables Dependent variables Our dependent variables are specified as firms’ value from the financial perspective in order to investigate the relationship between corporate sustainability and the values it creates. The financial market usually assesses a firm’s value on the basis of its future profitability. Under the assumption of a perfect capital market, the price of the security is the best available and unbiased estimate of the firm’s present value (Fama, 1970). In this study the measurement of firm performance and valuation is based on Tobin’s q, which considers price information. Tobin’s q, defined as the ratio of the market value of a firm to the replacement cost of its assets evaluated at the end of the fiscal year of each firm, has been widely employed in the field of corporate finance. There are still many authors such as Lang et al. (1996) who use it to proxy for the future investment opportunity set, like the growth prospects facing the firm. A benefit of using Tobin’s q is that it makes comparisons across firms relatively easier than comparisons based on stock returns or accounting measures where a risk adjustment or normalisation is required (Lang and Stulz, 1994). Due to limited information and complex computation for the real q data, we follow Chung and Pruitt’s (1994) approximating formulation of Tobin’s q. The approximate q is defined as the sum of market value, preferred stocks and debt over total assets. Here, market value is the product of a firm’s share price and the number of common stock shares outstanding; preferred stock is the liquidating value of the firm’s outstanding preferred stock; debt is the value of the firm’s short-term liabilities net of its short-term assets, plus the book value of its long-term debt. All the information mentioned is done so at the end of the year and is attainable from a firm’s basic financial reports. Sustainability dummy variable We define the proxy for corporate sustainability as a sustainability dummy which equals 1 if the firm is listed in the DJSGI USA in the current year or zero otherwise. Setting up a dummy variable for sustainable/other firms may lose information content since corporate sustainability is a kind of corporate evolution containing multiple levels (van Marrewijk and Werre, 2003). Unfortunately, no data are available for the sustainable score that each firm has gained in DJSGI. Following Allayannis and Weston (2001) (they set dummy variables for a hedger and non-hedger to investigate the relationship of using foreign currency deriva-

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tives and firm market value), setting a dummy variable to identify the sustainable firms and others is deemed suitable to cope with our research issues and to attenuate the research limitation we meet. Control variables To infer that sustainability increases the value of firms, it is necessary to exclude the effect of all other variables that could affect a firm’s value. In the following section we list the control variables included in the regression analysis and describe the theoretical reasons for adopting them. (1) Size: Most previous literature has found firm size to be negatively related to firm value (Mørck et al., 1988; McConnell and Servaes, 1990; Smith and Watts, 1992). We use the logarithm of total assets as the proxy for firm size. (2) Access to financial market: If firms give up projects from lacking necessary financing, their q value may remain high, because they only undertake positive NPV (net present value) projects (Allayannis and Weston, 2001). Accordingly, we use a dividend dummy as a proxy for the firm’s ability to access the market. This equals one if the firm paid a dividend in the current year. Firms are less likely to be capital constrained if they have paid a dividend, and thus this may induce a lower q (Lang and Stulz, 1994). Therefore, the dividend dummy is expected to be negatively related to q. (3) Leverage: Much of the theoretical and empirical literature has shown that a firm’s capital structure has an impact on its value (Allayannis and Weston, 2001; Palia, 2001). To control the capital structure effect, we use the debt to equity ratio by dividing total liabilities with total equity. (4) Profitability: If a firm is more profitable, then it is more likely to trade with a premium than a less profitable one might and thus increase its q. To control for profitability, we use return on assets (ROA), which is defined as the ratio of net income (loss) to total assets. (5) Sales growth: Growth in sales is generally found to be positively correlated with a firm’s value (Schmalensee, 1989; Hirsch, 1991). One-year sales change (percentage) is used to measure a firm’s sales growth. (6) Investment growth: Firm value also depends on future investment opportunities (Myers, 1977; Smith and Watts, 1992). R&D expenditure is one of the variables that has also been used mostly as a proxy for in-

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vestment opportunity (Mørck et al., 1988; McConnell and Servaes, 1990). Compustat does not report R&D expenses for all firms in all years, as more than half of R&D observations have missing values in our sample. Following Yermack (1996) and Servaes (1996), we use the ratio of capital expenditure to sales as proxy for investment growth. (7) Industrial diversification: There is ambiguous evidence as to whether industrial diversification leads to higher firm value. While several studies in the theoretical literature suggest that industrial diversification increases value (Williamson, 1970; Lewellen, 1971), there is still substantial empirical evidence showing that industrial diversification is negatively related to firm value (Lang and Stulz, 1994; Berger and Ofek, 1995; Servaes, 1996). To control the effect of industrial diversification, we follow Allayannis and Weston (2001) by using a dummy variable which equals one if the firm operates in more than one segment. In our sample, about 65 per cent of the firms are diversified across industries. (8) Credit quality: Credit quality, reflected in the credit rating of a firm’s debt, is likely to be associated with the firm’s value (Allayannis and Weston, 2001). We control credit quality by establishing a sevenscaled variable to specify the general credit rating of the firm: 7 for AAA firms, 6 for AA+ to AA−, 5 for A+ to A−, 4 for BBB+ to BBB−, 3 for BB+ to BB−, 2 for B+ to B−, 1 for CCC+ and below. (9) Industry effect: Firms are classified by the ten economic sectors in DJSGI. We control for industry effects by using these economic sectors dummies: consumer non-cyclical, consumer cyclical, energy, healthcare, industries, information technology, materials, telecommunication and utilities (financials are excluded).

Empirical results Our key finding is that sustainable firms are rewarded with higher valuations in the market place for large publicly-traded US firms. We firstly test the main hypothesis by using univariate tests, followed by a multivariate setting by controlling firm size, access to financial market, leverage, ROA, sales growth, investment growth, industrial diversification, credit quality and industrial effects. We also test the possibility whether corporate sustainability interacts with other control variables on the firm value. To minimise the endogeneity



problem in some specifications, we lag all our independent variables and find no significant change in our result.

Univariate tests In this subsection we test our main hypothesis that sustainable firms are rewarded by investors with higher valuations by comparing q values for sustainable firms and others. As the mean value of q is higher than the median value of q (see Table 3) which suggests that the distribution of q is skewed, we test our hypothesis using both means and medians. Table 4, panel A, presents the mean qs for the sample firms: the mean qs for sustainable firms is 2.5544, compared with a mean q of 1.6626 for others, which results in a sustainable premium of 0.8918. The premium is statistically significant at the 1 per cent level. In panel B we test our hypothesis by using the median qs. The median q for sustainable firms is 1.6397, compared with 1.1556 for others, suggesting a statistically significant difference of 0.4841. The results using both mean and median qs are consistent with our hypothesis that sustainable firms have a larger value than others.

Multivariate tests To further explore the relationship between corporate sustainability and its value, we need to control variables (firm size, access to financial market, leverage, ROA, sales growth, investment growth, industrial diversification, credit quality and industrial effects) that could affect q. We take a natural logarithm of Tobin’s q as the dependent variable. Table 5’s regression (1) presents the results of

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a pooled OLS regression. The main variable we use to test our hypothesis is the sustainable dummy that equals 1 if a firm is sustainable and 0 otherwise. The reported t-scores in the parentheses are based on White’s heteroskedasticity robust standard errors, which are consistent under homoskedasticity and under heteroskedasticity of any form. It can be found that the sustainability dummy has a positive impact on Tobin’s q and is statistically significant. Most control variables are statistically significant and signs of the coefficients are generally as predicted – consistent to the empirical results of the previous literature; for example, the study of Lang and Stulz (1994) and Allayannis and Weston (2001). We find that size is negatively related to Tobin’s q; firms with access to financial markets (proxied by a dividend dummy) have lower qs; more profitable firms (measured by ROA) have higher qs; and, similarly, firms with higher sales growth have higher qs. More diversified firms are less valuable than single-industry ones, which is consistent with the diversification literature. Finally, the credit quality is significantly positive related to q value and is also consistent with the prior literature. Economic sector dummies are also included, but suppressed in the table. To control for a firm’s unobserved characteristics that may affect firm value, we estimate fixed effects as regressions (2) shows. Similar to regression (1), we find a positive and significant relationship between sustainability and a firm’s value. The signs and significance of the coefficients of our control variable are similar to those in the pooled regression. We also implement a robust check by using a panel data technique with fixed and random effects. The Hausman test strongly rejects the

Table 4: Comparison of q: sustainable firms vs other firms

Panel A: Difference in means Mean Std Dev Panel B: Difference in medians Median Numbers of observations N

Sustainable firms

Other firms

Difference

t-statistics

p-value

2.5544 2.7121

1.6626 1.5802

0.8918

3.91

0.0001

1.6397

1.1556

0.4841

148

1,125