Firm Performance & Effective Mitigation of Adverse Business Scenarios

An important question for firm management and markets is whether superior capabilities to mitigate the impact of adverse business scenarios leads to higher firm performance and valuation. We address this question by using a new broadly applicable methodology based on the insight that effective risk management practices (e.g., operational, financial, strategic) should result in a ‘hedging profile’ with a lesser occurrence of ‘bad’ business outcomes relative to ‘good’ outcomes. We measure the hedging profile of 5,586 firms across 67 industries from quarterly earnings per share (EPS) reported in Compustat and relate it to firm performance using panel regressions while controlling for important firm characteristics including median earnings and firm/industry fixed effects. While median earnings proxy for differences in firm business performance (in each five-year window), positive earnings skewness reflects the ability to manage downside business risk. Regression estimation reveals a strong positive effect of the hedging profile on Tobin’s Q, excess returns and ROA (with R-squares between 55%-82%). Overall, our empirical findings show that firms with the capability to avert adverse business outcomes exhibit higher valuation and financial performance consistent with the signaling theory of risk management and a new channel of the shareholder value theory. Study results also provide support for our theoretical result that this capability should generate a premium in firm valuation