Diversity, Equity, and Inclusion

Alex Edmans is a Professor of Finance, Academic Director, Centre for Corporate Governance at London Business School, Caroline Flammer is a Professor of International and Public Affairs and of Climate at Columbia University, and Simon Glossner an Economist at the Federal Reserve Board in the Research and Statistics Division. This post is based on their recent paper. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite (discussed on the Forum hereby Alma Cohen, Moshe Hazan, and David WeissWill Nasdaq’s Diversity Rules Harm Investors? (discussed on the Forum here) by Jesse M. Fried; and Duty and Diversity (discussed on the Forum here) by Chris Brummer and Leo E. Strine, Jr.

Companies, investors, policymakers, and wider society are paying increased attention to diversity, equity, and inclusion (“DEI”) within firms. DEI initiatives have two motivations – that DEI improves a company’s long-term financial performance, and that it contributes to societal goals. Under both financial and social motives, the relevant measures of DEI are holistic. New ideas, and thus superior financial performance, stem from cognitive rather than purely demographic diversity. Similarly, social outcomes stem from providing opportunities to underrepresented groups across all areas, such as demographic, disability status, socioeconomic, and educational. Moreover, both goals require not only diversity but also equity and inclusion. Hiring minorities to tick a box, but failing to ensure that they can thrive and be themselves at work, will achieve neither the financial benefits of cognitive diversity nor the social outcomes of meaningful employment.

However, given measurement challenges, DEI metrics often focus narrowly on demographic diversity. For example, legal quotas or investor guidelines typically capture only the number of women on the board. Perhaps due to the narrowness of such a measure, academic research on the link between boardroom gender diversity and firm performance typically finds negative or insignificant effects. Similarly, company reports often include the percentage of females or ethnic minorities in the wider workforce, but neither measure captures cognitive diversity, nor equity and inclusion.

This paper takes a first step towards measuring the DEI of a company, employing proprietary data used by the Great Place to Work® (“GPTW”) to compile the list of the 100 Best Companies to Work For in America. Two thirds of the score that determines list inclusion stems from employee responses to the Trust IndexTM, a 58-question survey on various dimensions of employee satisfaction; the remaining one-third arises from a Culture AuditTM on a company’s demographic makeup, pay and benefits programs, and culture. Edmans (2011, 2012) finds that the Best Companies enjoyed superior long-term shareholder returns and earnings surprises over a 28-year period from 1984-2011, suggesting that the dimensions captured by the list are financially material. However, he only investigates list inclusion, since the individual responses to the 58 questions are confidential, as are the responses from companies that applied for the list but ended up unsuccessful.

Via a confidentiality agreement with GPTW, we obtained the individual responses to all 58 questions in the Trust Index, for all companies that applied to the list irrespective of whether they were eventually included, from 2006 to 2021. We identified 13 questions that cover DEI, such as “This is a psychologically and emotionally healthy place to work”, “I can be myself around here”, and “Managers avoid playing favorites.” We aggregate employee responses to form a measure that we call DEI. Our measure is a “grass-roots” indicator of actual DEI, as perceived by the responses of 250-5,000 employees in a company, in contrast to more superficial measures such as whether a company has a DEI policy.

As a preliminary result, we show that DEI is only weakly correlated with traditional measures of demographic diversity, such as the percentages of women and ethnic minorities in the board, senior management, CEO position, and wider workforce. DEI exhibits only a modest correlation with these measures; for example, its correlation with the percentage of female (minority) employees is 0.16 (-0.04). Thus, our DEI measure contains incremental information that would be missed by standard metrics that focus more narrowly on demographic diversity. This has implications for the significant attention paid to diversity metrics paid by companies, investors, employees, the public, the media, policymakers, regulation, and ESG rating agencies – they omit a big piece of the picture. Companies can “hit the target, but miss the point” – improve diversity statistics without improving DEI.

We then study the determinants of DEI, to understand how it is associated with recent financial performance and firm characteristics. We do not use the word “determinants” in a causal sense, because both financial performance and firm characteristics are endogenous. Rather, we are interested in studying what types of firms are associated with a higher level of DEI. We find that DEI is positively associated with one- and three-year sales growth, positively associated with three-year but not one-year stock returns, negatively associated with leverage, and positively associated with dividends. This suggests that a strong financial position frees a company from having to focus on short-term pressures and instead allows it to address longer-term challenges such as DEI. Small and growth (low book-to-market) firms are associated with higher DEI, consistent with their greater ability to increase DEI, given management’s proximity to workers, and their greater incentives to do so, given the importance of human capital in such firms.

We then study the workplace policies and practices that are associated with DEI. The proportion of women in senior management is positively and significantly associated with DEI across all specifications. However, there is no link between DEI and the presence of a female CEO and a negative association with the percentage of women on the board. We also find that DEI is unrelated or negatively related to ethnic diversity in senior management, at the CEO level, or in the boardroom. The insignificance of most demographic diversity variables suggests that an “add diversity and stir” approach is insufficient to improve DEI.  We also explore workplace policies, such as childcare, unpaid parental leave days, sabbaticals, and flextime, to test whether DEI can be easily increased by implementing simple policies. In contrast to this hypothesis, all workplace policies are insignificantly associated with DEI. In addition to policies, we also show that voluntary turnover has no link with DEI, and the percentage of unionized workers is negatively linked. This suggests that DEI cannot be increased by general efforts to improve the workplace, but instead requires specific, targeted initiatives.

We then turn to the consequences of DEI, which we again do not interpret causally. We find that DEI is positively associated with seven out of eight measures of future profitability, such as return on assets, return on sales, profits divided by employees, and sales divided by employees. These results are after controlling for the percentages of female and minority employees; indeed, these variables are insignificantly related to almost all performance measures. In short, DEI is correlated with higher profits, but diversity alone is not. We also find that DEI is positively associated with valuation measures, such as Tobin’s Q, suggesting that the market at least partially incorporates the value of DEI. However, we also find that DEI is positively linked to future earnings surprises, indicating that the market does not fully incorporate the performance benefits of DEI.

We also study future innovation performance. DEI is unrelated to either the number of future patents or patent citations. However, the granular nature of our data allows us to stratify the survey responses by job category. We find that DEI perceptions of professionals, a job category that includes R&D staff, are positively and significantly correlated with both innovation measures, but there is no positive link with the responses from the three other categories: executives, managers, and hourly workers. This is consistent with the fact that innovation is most likely to stem from professionals.

Finally, we study future stock returns. Somewhat surprisingly, given prior results on profitability, innovation, and earnings surprises, we find no link between DEI and stock returns, after controlling for either firm characteristics in firm-level regressions or risk in portfolio regressions.

The complete paper is available for download here.

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