In recent years, investors have learned that defining the market value of a firm cannot just be based on finances. GAAP and FASB standards require financial reporting of earnings, cash flow, and profitability – all measures that investors have traditionally examined. But recently, these financial outcomes have been found to predict only about 50% of a firm’s market value. Another challenge is that this financial information has become widely known and shared, meaning that the investor insights it affords are hardly unique.
To gain more insights into a specific firm, investors have shown more interest in intangibles like strategy, brand, innovation, systems integration, collaboration, and so on. Investors have also worked to track and measure these intangibles, even if more subjective. We believe that a next step for investors is to analyze the predictors and drivers of these intangible factors — which means focusing on leadership.
Wise, long term investors recognize that leadership affects firm performance. But too often, assessments of leadership are haphazard and narrow. For instance, in our research, we found that investors allocate about 30% of their decision making based on quality of leadership, and they have much less confidence in their ability to assess leadership than in their assessments of financial or intangible performance. Investors may say “this leader is charismatic, has a vision, or treats people well” but there is little analysis behind what has often become a “gut feel” approach. Investor assessments of leadership should go beyond isolated observations to more rigorous evaluation. Numerous studies have shed light on what good leadership is; synthesizing this research into useful insights for investors would help counteract intuitive leadership assessments.
What we need is a leadership capital index, similar to a financial confidence index (such as Moody’s or Standard & Poor’s). It would move beyond casual and piecemeal observations of leaders to more thorough assessment of leadership.
It’s important to note that 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, but offering an opinion about the 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.
We’ve created a leadership capital index by interviewing and surveying investors and by synthesizing at dozens of studies of the impact of leadership. In general, these studies offered deep insights on one piece of an overall leadership puzzle. Some focused on personal leadership style of the CEO, 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.
The leadership ratings index we have developed has two dimensions, or domains: individual and organizational. Individual refers to the personal qualities (competencies, traits, characteristics) of both the top leader and the key leadership team 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. Each domain consists of five factors:
Individual:
Organizational:
While it may not be easy to precisely track each of these 10 elements, when investors include them in interviews, observations, surveys, and reports, they will dramatically increase their ability to realize full firm value. Equity investors (venture capitalists, private equity, portfolio managers, mutual/hedge fund managers) will use this index to complement existing financial and intangible analysis and gain a more thorough and rigorous understanding of firm’s full market value. Debt holders will have more confidence in a firm’s ability to repay its debt. With this index, rating agencies (ISS, government groups, Moody’s) can offer a more refined assessment of the firm’s full value by including leadership in their ratings process. 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. Each of these processes could be upgraded with a disciplined and through approach to assessing leadership.
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. The leadership capital index will help investors and others improve their approach to firm valuation. When leadership capital becomes a factor in investor judgments, it will naturally receive more emphasis in day-to-day corporate life, to the benefit of many. It is now time for investors and others to use a leadership capital index.
By David Ulrich and Allan Freed
Source: Harvard Business Review
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