Two firms in the same industry with the same earnings would be expected to have similar market value, but they don’t. In recent years, investors have learned that defining the market value of a firm may be based on earnings, but goes beyond. Recently traditional financial outcomes (e.g., cash flow, EBITDA) have been found to predict about 50% of a firm’s market value. To gain more insights into a specific firm, investors have shown increased interest in intangibles like strategy, brand, R&D, talent, collaboration, innovation, risk, and information flow. A next step is for investors to use a disciplined methodology for measuring the impact of leadership on market value.
Wise, long-term investors recognize that leadership matters. In our research, we found that investors allocate about 30% of their decision making on the quality of leadership. Quality of leadership predicts intangible value which in turn produces financial results. But too often assessments of leadership are haphazard and narrow. Investors may say “this leader is charismatic, has a vision, or treats people well” but there is little analysis behind what has become a ‘gut feel’ approach to assessment among many investors. Leadership assessments should go beyond isolated observations to more rigorous analytics. To move firm valuation discussions from financials to intangibles to leadership requires synthesizing massive studies and insights about leaders and leadership into a useable and simple leadership valuation solution.
My forthcoming book, The Leadership Capital Index: Realizing the Market Value of Leadership draws on a useful metaphor for how to include, conceive, and audit leadership in the assessment of firm value. A leadership capital index is like a financial confidence index — Moody’s or Standard & Poor’s. It moves beyond casual and piecemeal observations of leaders to more thorough assessment of leadership.
A leadership index differs from a leadership standard. Standards define what is expected; indices rate how well an activity performs. For example, consider the Economist’s Big Mac index, which measures the cost of a Big Mac in various countries in terms of its difference from the average Big Mac price in the United States. It doesn’t try to tell you how much a Big Mac should cost—instead, it is a crude but useful assessment of the cost of living around the world.
An index guides investors to make more informed choices. When a rating agency like Moody’s or S&P downgrades a company, it is not saying the company did or did not meet financial reporting requirements. It is offering an opinion about the firm’s ability to repay loans in the future. Likewise, a leadership capital index would inform investors about the readiness of the firm’s leadership to meet business challenges.
To create a leadership capital index, I also looked at dozens of studies by consulting firms and experts who put substance behind the assessment of leadership. In general, these studies offered deep insights on one piece of an overall leadership puzzle. Some focused on personal leadership style, others on compensation or training practices, and still others on organization governance and design. Few attempted to prepare a comprehensive approach to leadership as a whole that could be accessed by investors.
My leadership ratings index has two dimensions, or domains: individual and organizational. Individual refers to the personal qualities (competencies, traits, characteristics) of the key leaders in the organization. Organizational refers to the systems these leaders create to manage leadership throughout the organization and the application of organization systems to specific business conditions. Using these two domains, previous leadership and human capital work may be synthesized into a leadership capital index that investors can use to inform their valuation decisions.
This leadership capital index will have relevance for many stakeholders interested in firm valuation. Equity investors (venture capitalists, private equity, portfolio managers, mutual/hedge fund managers) will have a more thorough and rigorous way to evaluate and realize a firm’s full market value. Debt holders will have more confidence in a firm’s ability to repay its debt. Rating agencies (ISS, government groups, Moody’s) can offer a more refined assessment of the firm’s full value by including leadership in the assessment. Boards of directors can have a more thorough process for evaluating the quality of leadership within their organization. C-suite executives who have primary responsibility for firm value can include leadership as part of this discussion. Leadership development specialists charged with developing leaders can focus less on personal characteristics of leaders and more how investors might view them.
Realizing the market value of leadership could also have a significant impact on many organization processes: risk management, governance, social responsibility, reputation, and leadership development.
Transitioning from a gut feel or narrow assessment of leadership to an index that can start to predict the impact leaders have on intangible value creation changes the game of leadership assessment and development. It provides stakeholders with a clearer lens through which to see the impact of leadership in realizing full market value. It is now time for investors to use a leadership capital index.
Dave Ulrich (ude.h1501100690cimu@1501100690uod1501100690) is Rensis Likert Professor of Business at the University of Michigan and a Partner at the RBL Group. His latest book is The Leadership Capital Index (Berrett Koehler, September).