Dissecting the Ethics Premium

Earlier this month Ethisphere published is 2019 list of World’s Most Ethical Companies. As always, Ethisphere was also quick to call out what it has dubbed the Ethics Premium: the better stock performance of WME companies compared to large companies overall. Over the last three years, WME firms have outperformed their peers by 10.5 percent.

I wondered: how do WME firms perform against their peers on other metrics of financial success? After all, stock price appreciation reflects what investors believe about highly ethical companies. How well do WME firms perform on operating metrics like revenue, income, or return on assets?

So I visited Calcbench.com, purveyor of financial data (and, in full disclosure, Radical Compliance business partner), to research the question.

First, the background. To define the most ethical of the WME companies, I used 10 firms that have been on the Ethisphere WME list at least 12 of the 13 years that Ethisphere has published its list. They are:

  • Aflac
  • Deere & Co.
  • Ecolab
  • Fluor Corp.
  • General Electric
  • International Paper Co.
  • Pepsico
  • Starbucks
  • Texas Instruments
  • Xerox

For each company, I examined average annual revenue, operating income, shareholder equity, and return on assets, 2013 to 2018. Then I compared those numbers against the same metrics for the S&P 500 minus those 10 firms. What did I find? Well…

Return on Assets Is Better

Return on assets is a company’s net income divided into total assets. Essentially, it measures how efficiently a company turns a dollar of revenue into profit. You express ROA as a percentage. The higher that percentage is, the better; and any company with an ROA above 10 percent is doing quite well.

As you can see from Figure 1, below, my WME companies have a higher ROA than their peers. That’s good.

Even better, the WME group’s return on assets is accelerating. You can see that in the 2018 numbers at the end, pulling away from the S&P number.

That higher ROA performance is intriguing, because it validates other research published by researchers at George Washington University last fall. Those folks found that companies with better rates of internal whistleblower reporting also had higher ROA than their peers with ordinary internal reporting activity.

I don’t know how much weight Ethisphere placed upon whistleblower protections and internal reporting when it evaluated its WME firms — but those issues had to count for some part of the score, and it’s a safe bet that WME firms do well on internal reporting.

So now we have to pieces of evidence pointing in the same direction: that ethical companies are better run firms.

Revenue Growth Is Flat

On the other hand, the WME firms don’t seem to have any special advantage in revenue growth. They have more revenue, because they’re larger firms; but revenue growth tracks pretty much in line with the S&P 500. Indeed, in the last two years or so, the S&P 500 have done marginally better at revenue growth. See Figure 2, below.

That’s not ideal for the corporate ethics community trying to sell a great message, but it may not portend trouble, either. All 10 WME firms are large firms — like, really big. Even the smallest of the lot, Xerox Corp., still had $9.8 billion in revenue last year.

Large, established companies generally grow more slowly than smaller firms, so we can’t say with any certainty that a strong commitment to ethics slows growth. It might be more accurate to say a strong commitment to ethical conduct makes a company’s earnings less volatile, because the firm is less likely to suffer lawsuits, regulatory fines, or loss of key employees plagued by scandal. We’d need more research to know for sure.

Operating Income Is Lower*

Figure 3 compares operating income between WME firms and the S&P 500 — and at first glance, this looks bad. After outperforming for a few years in the mid-2010s, operating income from the WME tanked in the last two years.

Charts like this can give executives heartburn, because operating income depends on the company’s expenses, and we all know that the ethics & compliance function is a cost center. Nosedives like this may prompt some CFOs to pull out the scalpel when reviewing your budget request.

But wait! That dip starting in 2017 can be explained away in two words: General Electric.

As we have documented elsewhere, GE is in terrible shape these days. The company had an $8.5 billion operating loss in 2017, followed by (gulp) a $20.7 billion operating loss in 2018. When you recalculate this chart without GE in the WME (and Ethisphere did drop GE off its list this year), you see a much better Figure 4, below.

Stockholder Equity Drifts

You can see a similar pattern in stockholder equity (that is, the remaining value of the firm that goes to shareholders, after netting out the company’s assets and liabilities). Take the WME firms as a whole, and stockholder equity did not at all look good relative to peers; Figure 5, below.

Remove GE from the WME group, however (and GE’s spluttering stock price too), and the picture looks much better. Growth in stockholder equity is still drifting downward from the S&P 500, but to a much lesser degree. Figure 6, below.

The Ethics Premium in Perspective

We could quibble with these data and charts all day, and obviously a larger sample of WME firms would give us a better approximation than the 10 highly ethical firms I flagged here.

Still, we can’t deny the most important chart of all, back at the top of this post: average return on assets is higher among highly ethical firms. Higher ROA means the WME firms are better at turning revenue into profit.

Meanwhile, WME firms also have a higher average share price than their peers — and as corporate finance gurus know, share price is a function of expected future profit. So when a company’s stock price is outperforming its peers, the market is saying it expects that company to generate more profit in the future.

Those two concepts aren’t identical, but they are quite similar. So perhaps when we talk about an ethics premium for doing business right, there’s something to it.

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