Is employee satisfaction good or bad for firm value? While it may seem natural that companies should do better if their workers are happier, this relationship is far from obvious. The 20th-century way of managing workers (e.g. Taylor 1911) is to view them as any other input – just as managers shouldn’t overpay for or underutilise raw materials, they shouldn’t do so with workers. High worker satisfaction may be a sign that workers are overpaid or underworked. However, the world is different nowadays. Human capital is the main asset in many firms (Zingales 2000), and employee welfare can improve productivity, retention, and recruitment.
Testing the relationship
Evaluating these competing views, and studying the effect – if any – of employee satisfaction on firm value is difficult because of reverse causality. It may be that firm performance causes employee satisfaction – firms that are performing well can afford to spend money on worker welfare, and employees feel happier when working for a successful firm.
The link between employee satisfaction and firm value has been studied by an extensive literature in management (see, for example, the survey of Margolis and Walsh 2003), which typically measures firm performance using accounting profits or valuation ratios. I decided to tackle this long-standing management question using a methodology from a different field – finance. This approach involves linking employee satisfaction not to profits, but to future stock returns, which reduces reverse-causality concerns. If it were high profits that caused employee satisfaction, then the high profits would mean that the company’s stock price would already be high today, and so we shouldn’t expect higher stock returns going forward.
In Edmans (2011, 2012), I measured employee satisfaction using the list of the “100 Best Companies to Work For In America”. This list is arguably the most respected and thorough measure of employee satisfaction available, and is compiled by surveying the employees themselves – it’s the ultimate in fundamental, grass-roots analysis. 250 workers are randomly selected in a firm and asked 57 questions on various aspects of employee satisfaction (credibility, respect, fairness, pride/camaraderie). The list first came out in a book in March 1984, then in another book in February 1993, and then in the January edition of Fortune magazine every year from 1998. It’s thus available for a long time period that includes both recessions and booms.
My methodology involves buying a portfolio of the Best Companies in April 1984, updating it in March 1993 for the new list, and then every February from 1998. The one-month delay is because I wish to test not only whether employee satisfaction improves firm value, but also whether the market recognises this link. Any effect of employee satisfaction on firm value should be incorporated in stock prices when the list is published, so I should only find abnormal returns if the market is inefficient.
Controlling for other determinants of stock returns – market performance, industry performance, firm characteristics, and risk – I find that the Best Companies outperform by 2-3% per year over a 26-year period from 1984–2009, which is highly statistically significant.
The result has three main implications.
- First, employee satisfaction is beneficial for firm value, consistent with new human relations theories.
- Second, the market does not seem to recognise this link.
Even though the Best Companies list is public information, and I wait a month before forming my portfolios, the strategy generates superior returns. This may be because traditional methods of valuing companies are based on the 20th-century firm, and emphasise tangible factors such as short-term profits.
- Third, Socially Responsible Investing can add value.
The traditional view is that Socially Responsible Investing is costly to investment performance, as it involves screening out good investments and screening in bad investments. However, the Best Companies strategy allows investors to do well (generate high returns) and do good (support companies that treat employees responsibly). This result is a consequence of the first two implications – employee satisfaction is beneficial, but the market doesn’t recognise that it’s beneficial.
The global context
The above studies only focus on the US. It is not clear whether these results can be generalised to other countries. In particular, the costs and benefits of employee satisfaction likely depend on the institutional context. In flexible labour markets, hiring is easier (due to fewer constraints on the contracts firms can offer) and so the recruitment benefits of employee satisfaction are stronger. Since one’s rivals also face few hiring constraints, the retention benefits of employee satisfaction are also more important. Flexible labour markets also feature fewer firing constraints. Since it’s easier for firms to dismiss underperforming workers and replace them with superior ones, the recruitment benefits of employee satisfaction are again greater. The motivational benefits are also likely higher. Under the efficiency-wage theory of Shapiro and Stiglitz (1984), workers exert effort to avoid being fired from a satisfying job, and thus employee satisfaction has greater motivational impact when the likelihood of firing is stronger.
In regulated labour markets, hiring and firing are harder, and thus the recruitment, retention, and motivational benefits are lower. In addition, expenditure on employee satisfaction is likely to exhibit diminishing marginal returns. When labour-market regulations already ensure a minimum level of worker welfare, companies with high satisfaction relative to their peers may be exceeding the optimal level – the marginal benefit of their expenditure may not justify its cost.
In a new paper (Edmans et al. 2014), my colleagues and I study the link between employee satisfaction and stock returns in 14 countries around the world. We first find that the alphas I documented for the US (Edmans 2011, 2012) are not anomalous in a global context. The Best Companies alpha in the US, of 22 basis points per month, is only the 10th-highest out of 14. For example, the monthly alpha is 77 basis points in Japan and 81 basis points in the UK. However, there’s also significant heterogeneity across countries – Germany exhibits a negative alpha of 45 basis points. Thus, while the Edmans (2011, 2012) results generally hold out of sample, they do not extend to every country.
We next study whether the outperformance is related to a country’s labour-market flexibility. We measure labour-market flexibility in two ways: the OECD Employment Protection Legislation index and the labour-market flexibility categories of the Fraser Institute’s Economic Freedom of the World index. Using both measures, we find that the abnormal returns to Best Companies are significantly increasing in labour-market flexibility. Thus, the Best Companies do generate superior returns outside the US, but only in countries with high labour-market flexibility.
Overall, our results suggest that the association between employee satisfaction and stock returns depends critically on the institutional context. These results have important implications for both managers and investors. Starting with the former, they do not suggest that managers should necessarily increase expenditure on employee-friendly programs – it depends on the country’s labour-market flexibility. Moving to the latter, given that the vast majority of empirical asset-pricing studies that uncover alpha are based on US data, the results emphasise caution in applying these strategies overseas. This caution is especially warranted for strategies that are likely to be dependent on the institutional or cultural environment, such as Socially Responsible Investing. Just as the value of employee satisfaction depends on the flexibility of labour markets and existing regulations on worker welfare, the value of other Socially Responsible Investing screens such as gender diversity, animal rights, environmental protection, and operating in the tobacco, alcohol, and gambling industries, also likely depend on regulations and cultural norms.
Edmans, Alex (2011), “Does the Stock Market Fully Value Intangibles? Employee Satisfaction and Equity Prices”, Journal of Financial Economics, 101: 621–640.
Edmans, Alex (2012), “The Link Between Job Satisfaction and Firm Value, With Implications for Corporate Social Responsibility”, Academy of Management Perspectives, 26: 1–19.
Edmans, Alex, Lucius Li, and Chendi Zhang (2014), “Employee Satisfaction, Labor Market Flexibility, and Stock Returns Around the World”, Working Paper, London Business School.
Margolis, Joshua and James Walsh (2003), “Misery Loves Companies: Rethinking Social Science Initiatives by Business”, Administrative Science Quarterly, 48: 268–305.
Shapiro, Carl and Joseph Stiglitz (1984), “Equilibrium Unemployment as a Worker Discipline Device”, The American Economic Review, 74: 433–444.
Taylor, Frederick (1911), The Principles of Scientific Management, New York.