28 Years of Stock Market Data Shows a Link Between Employee Satisfaction and Long-Term Value

Alex Edmans for Harvard Business Review, March 24 2017. Looking to invest in #jobsatisfaction? Convince your stakeholders with these numbers.

Does employee satisfaction improve firm value? The answer to this question is not obvious. While it seems natural that satisfaction will facilitate worker recruitment, retention, and motivation, investing it is costly. So the question is, do the benefits outweigh the costs?

The answer is a resounding yes. In a paper in the Academy of Management Perspectives, summarized in a TEDx talk, I studied 28 years of data and found that firms with high employee satisfaction outperform their peers by 2.3% to 3.8% per year in long-run stock returns – 89% to 184% cumulative – even after controlling for other factors that drive returns. Moreover, the results suggest that it’s employee satisfaction that causes good performance, rather than good performance allowing a firm to invest in employee satisfaction.

I measured employee satisfaction using the list of the 100 Best Companies to Work For in America. This list has two advantages. First, it has been around since 1984, so I have tons of data and can ensure that any relationship holds generally, rather than being specific to a particular time period. Second, the list is particularly thorough. Some prior studies measure employee satisfaction by asking managers how much they care about their workers, which is prone to manipulation. Instead, this list is compiled independently by the Great Place To Work Institute, which selects 250 workers at random and asks them 57 questions, spanning credibility, respect, fairness, pride, and camaraderie. As a result of its thoroughness and independence, the measure is extremely well respected by both managers and employees alike.

The second question is how to measure performance. Prior research typically looks at profits. However, this leads to the aforementioned causality issue – does satisfaction improve profits, or do profits lead to satisfaction? Looking at futureprofits doesn’t solve the issue, because profits are persistent. For example, if I found that satisfaction in 2015 was associated with high profits in 2016, it could be that high profits in 2015 led to both high satisfaction in 2015 and also high profits in 2016. The same issue arises when studying firm value (e.g. P/E or M/B ratios) rather than profits: firm value is similarly persistent.

I thus decided to tackle the causality issue by measuring performance using long-run stock returns. After controlling for momentum, stock returns aren’t persistent; for example, if high stock returns in 2014 lead to high satisfaction at the start of 2015, these high stock returns don’t necessarily persist in 2015 – a stock that has done well in 2014 should be equally likely to outperform as underperform in 2015. Separately, studying long-run stock returns addresses any issue with the stock market being myopic, i.e. taking time to incorporate the benefits of employee satisfaction. To isolate the effect of employee satisfaction, I control for the industry that the firm is in, firm size, recent performance, dividend yield, growth opportunities, risk, and several other factors. (These other factors and controls are explained in more detail in the paper.) After doing so, I end up with my 2.3% to 3.8% annual outperformance.

The results have implications for both managers and investors. For managers, they imply that companies that treat their workers better, do better. While seemingly simple, this result contradicts conventional wisdom, which uses cost control as a measure of efficiency. For example, Costco is known for paying its workers significantly above the industry average, and gives them healthcare benefits after a significantly shorter period of service. An equity analyst was quoted in Businessweekas saying that “[Costco’s] management is focused on … employees to the detriment of shareholders. To me, why would I want to buy a stock like that?” Indeed, prior research found consistent support for the conventional view. A study in the prestigious American Economic Review found that announcements of pay increases reduce market valuations dollar-for-dollar, consistent with the zero-sum view that a dollar paid to workers as a dollar taken away from shareholders. Another study on German co-determination found that greater employee involvement reduces profitability and valuation.

In contrast, I find that the benefits of employee satisfaction outweigh the costs. These different results may stem from using a superior and more comprehensive measure of employee satisfaction, which consists of more than just pay and involvement. One might think that there is a finite optimal level of employee satisfaction – that firms at the very top of the list may be over-investing and underperform. However, I find no evidence of this. This may be because firms generally underinvest in employee satisfaction – perhaps because of the traditional view that doing so is simply wasteful expenditure – and so even the top firms have not crossed the optimal level.

So what are the implications for investors? Just because managers should invest in employee satisfaction doesn’t necessarily mean that investors should also. If a characteristic is good for firm value, but the market recognizes that it’s good, then it should already be in the stock price – just like how investors shouldn’t automatically invest in the market leader in an industry, since the stock price will already take this into account.

The Best Companies is public information, and so their stock prices should immediately jump upon list publication – particularly since the Best Companies are large firms and so followed by most investors. However, I find that it takes the market four to five years before it fully incorporates this information. While the market is good at valuing tangible assets, such as profits and dividends, it is very slow at valuing intangibles such as employee satisfaction – perhaps because it wrongly thinks that employee-friendly companies are distracted from the bottom line and doesn’t view satisfaction as a desirable characteristic. This result potentially extends beyond employee satisfaction and towards other dimensions of corporate social responsibility (CSR), since they’ll also be ignored by investors who doubt their benefit for firm value. As a result, even a traditional investor who targets purely financial returns may wish to pay attention to CSR characteristics.

Moving back to managers, the market’s slow reaction to employee satisfaction implies a double-edged sword. While investing in employee satisfaction does pay off, it takes the market a long time to recognize its benefits. Thus, a CEO who is concerned with meeting quarterly earnings targets may choose not to invest in employee morale – and in so choosing, hurt her company’s long-term performance. Both investors and directors can take actions to mitigate this. Investors should look beyond quarterly reports. Indeed, Unilever’s CEO Paul Polman stopped reporting quarterly earnings to allow the company (and its investors) to focus on long-term value. Similarly, boards of directors should give managers equity with long vesting periods, rather than deciding their bonuses or whether to retain or fire them based on short-term profit. The problem of short-termism is systemic – managers will only think long-term when the directors and investors who evaluate them do so also.

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