Director Alpha

An individual director on the board of a public company could affect the firm’s value by about 1% of its market capitalization, on average.

That’s the conclusion of new research by UW Foster School of Business researchers Christopher Hrdlicka, an assistant professor of finance, Jarrad Harford, a professor of finance and the Paul Pigott/PACCAR Professor in Business Administration, and Aaron Burt, a Foster PhD Program graduate and assistant professor of finance at the University of Oklahoma.

Considering that public companies can range in value from hundreds of millions to a trillion dollars, 1% is no small number.

But Hrdlicka is quick to point out the nuance of the finding. “We have to be careful how we interpret the word ‘value,’” he says. “It’s not accurate, for instance, to say that a director is worth 1% of a firm’s market cap. In other words, you can’t add a second director and expect a 2% market-cap gain.”

Rather, the data reveals that directors have a clearly identifiable impact and puts a ballpark number on how much a director’s input could move a firm’s value, up or down.

Tough to quantify

The value of an individual corporate director has proven notoriously difficult to quantify. Previous studies have had to look at sudden events, like the death of a director, and attempt to isolate the change in a firm’s value after the event.

But Harford, Hrdlicka and Burt used an innovative approach to tease out the value effect of a director. They identified and paired up the stock-market returns of companies that shared the same director, studying the co-movement of the two companies’ prices.

Here’s how their analysis worked. Say, for instance, that Director Smith is on the boards of both firm A and firm B. Firm A announces good news in March, so the researchers pair firm A’s March stock returns with firm B’s April stock returns. Essentially, firm A issued a signal that good things were happening. If Director Smith was at all responsible for this boost, his impact will also appear over time at firm B. These lagged-pair data sets should show positive excess returns over time if a director is adding value. And they should show negative excess returns over time if a director is decreasing value.

And that’s precisely what they did, to the tune of 1% up or down.

Hrdlicka points out that 1% is probably underestimating the impact. Market returns are tricky to work with because so many factors drive stock-market movements, complicating the effort to isolate any one factor. The lag in data between linked firms helped the authors “decontaminate” the data, but it also likely undervalues the full impact of a given director.

Director alpha

The research identifies a quantifiable “director alpha”—alpha being investor-speak for performing better than the stock market as a whole over an extended period.

Whenever alpha persists in a mostly efficient stock market, researchers have to ask why. Is it because of trading frictions, where investors can see the profit opportunity but can’t find shares to buy or sell on a particular day? Or is it because of investor inattention, meaning that investors aren’t generally seeing the opportunity, either because they aren’t looking or because the relevant information is hard to get?

The authors find that director alpha is driven by investor inattention, not by trading frictions. This implies that investors don’t—or can’t—monitor the performance of directors in real time.

A methodology that opens doors

The study’s insights have implications for boards, shareholders and would-be investors. For instance, data on the value of a director could guide a board’s decision to censure or reward an appointee.

But the approach that the authors used to measure a director’s impact actually has much broader implications. “It’s a form of an event study, but without the pressure to wait for an event,” Hrdlicka says.

Event studies in asset pricing look at what happens after the announcement of a big, isolated event—an acquisition or a major asset sale, for instance.

Now the linked-company method designed by Hrdlicka, Harford and Burt presents a new way to evaluate a potential driver of company value, like an individual director, or any other factor that could link two companies, like a shared supplier or a shared regional footprint. “The paper gives companies a new fact about directors,” says Hrdlicka, “and it gives researchers a new tool.”

“How Much Do Directors Influence Firm Value?” is forthcoming in the Review of Financial Studies.