The relationship between corporate social performance and corporate financial performance and the mediating effect of the reputation of firms

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MASTER THESIS

The relationship between corporate social performance and corporate financial performance

and the mediating effect of the reputation of firms

Name: M.A.X. van Merrienboer

Student number: 10670211

Date of submission: 10 June 2014/final draft

Qualification: Master Business Studies: Strategy

Institution: Amsterdam Business School, University of Amsterdam

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ABSTRACT

The effect of corporate social performance (CSP) on firm financial performance (CFP) has been previously investigated with mixed results. Researchers have found evidence for a negative, neutral and positive relationship between CSP and CFP. This thesis intents to investigate the effect of CSP, constructed as a capability to manage a wide spectrum of stakeholders, on the financial performance of firms. The building of good relationships with stakeholders like employees, the environment, diversity and the community could enable firms to develop valuable and hard-to-imitate intangibles that may be a source of competitive advantage, affecting financial performance positively. Since corporate reputation is an intangible that may arise from building better stakeholder relations, or simply from an increase of the firm’s level of CSP, the CSP-CFP relationship could be mediated by a firm’s reputation. These hypotheses are tested with data from merely US companies between 2006 – 2012. This thesis estimates the effect of CSP by regressing CFP on CSP. The KLD database is selected to measure CSP, while both ROA, ROE and MVA are operationalized as proxies for CFP and corporate reputation is indicated by the Fortune 500 Reputational Index Score. The model controls for firm size, investment in R&D and industry effects, given that previous studies suggest that these variables could be an important determinant of CFP. The results of the empirical analysis show that there is indeed a clear positive relationship between CSP and CFP. Evidence suggests that this positive relationship is based on a direct effect of CSP on CFP, but also on indirect or mediating effect of corporate reputation. Moreover, regarding the relative contributions of stakeholder groups, both the diversity and employee CSP dimensions are vital for CFP, while the environmental CSP indicator illustrates a negative relation between CSP and CFP. These results provide useful contributions to managers and researchers, and at the same time present possible directions for future research.

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2.1 CFP indicators ... 29 2.2 CSP indicator ... 29 2.3 Reputation indicator ... 30 2.4 Control variables ... 31 V. Results ... 32 1. Descriptive Statistics ... 32 2. Correlation Analysis ... 34 2.1 H1 & H2 ... 34 2.3 H3 ... 36 2. Regression Analysis ... 36 2.1 H1 ... 36 3.2 H2 ... 40 4. Mediation analysis ... 42

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VI. Discussion ... 47

1. Theoretical implications ... 50

2. Managerial implications ... 54

3. Limitations & Future research ... 55

VII. Conclusions ... 59

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I. Introduction

Long after the introduction and recognition of the concept of corporate social responsibility (CSR) as an “almost universal practice” (Dressel, 2003: 1), there are still a lot of unsolved mysteries with respect to CSR. Next to the ethical debate, which was launched by Friedman (1970) through stating that corporations are inappropriate and inefficient agents of social change that should therefore not engage in voluntary contributions to social causes, many researches have tried to examine the “business case for CSR”. The latter primarily deals with the question whether, to what extent and in which direction corporate sustainability performance (CSP) and corporate financial performance (CFP) relate. Besides the aforementioned topic, instrumental stakeholder theory (Jones, 1995) suggests a positive relationship between CSP and CFP, since the satisfaction of various stakeholder groups is instrumental to financial performance (Donaldson & Preston 1995; Jones, 1995). Building on theoretical elements of Freeman (1984) and Harrison et al. (2010), one could argue that firms may thus benefit financially from attending concerns towards the creation of stakeholder value, instead of solely focusing on creating value for their shareholders.

However, the relationship between CFP and CSP gives rise to contradictory research, both theoretically as empirically. With regard to the empirical studies, researchers find evidence for a negative relation (Aupperle et al., 1985), no relation (Surroca

et al., 2010) and a positive relation (Orlitzky et al., 2003) between CSP and CFP. This contradictory

research leaves room for confusion and skepticism (Margolis & Walsh, 2003). According to Barnett (2007), it is – even after thirty years of research – still not possible to conclude whether or not CSR expenditures lead to financial benefits. The theory of stakeholder mismatching (Wood & Jones, 1995) characterizes this inability by stating that firms are unable to identify variables that represent the stakeholders that are relevant for the CSP. Trying to solve this stakeholder mismatching problem, Hillman & Keim (2001) disentangle CSR into stakeholder management and social issue participation. They find a positive relationship between stakeholder management and CFP, while finding a negative relationship between social issue participation and CFP. However, when further decoupling stakeholder management into various categories of stakeholders – such as product, environment,

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5 employee relations, diversity and community – Hillman & Keim (2001) are unable to find significant results for every single dimension of stakeholder management, which indicates a promise for further research. Bird et al. (2007) also identify these five distinct CSR activities and investigate to which extent these activities contribute to CFP. However, while the focus is on five CSR activities; they do not assign these activities to specific stakeholder groups, which will be the central perspective within

this study. Because the concepts of stakeholder

theory and CSR are seen as fundamental to the study of business and society (Maron, 2006), there is a strong need for conclusive and unambiguous results regarding the CSP-CFP relationship. The inconsistency in the results of studies are of concern (Griffin & Mahon, 1997; Maron, 2006; Wu, 2006). Since Maron (2006) proposes the need for a unified underlying theory with regard to the CSP-CFP relationship, more research is demanded (Beurden & Gössling, 2008). Therefore, this study dives into the named relationship by constructing a framework of various stakeholders groups (environment, employees, diversity and community) that may influence the relationship between CSP and CFP. This framework builds on different measures of CSP by disentangling CSP into the given stakeholder groups, while using both market-based and accounting-based measures for CFP. Moreover, it seems that the concepts of stakeholder theory, CSP and CFP are all related and possibly even mediated by corporate reputation. Therefore, the framework includes a measure for corporate reputation. The construction of the theoretical framework is followed by an assessment of the empirical relationship and mediating effect of reputation on CSP and CFP. Given the ambiguous results and aforementioned shortcomings of empirical studies, there is no consensus about the question which specific stakeholders firms should target with their CSR activities if they intend to enhance their CFP. This thesis intends to clear the aforementioned lack of agreement among scholars (quantitative) and researchers (qualitative) about the existence and direction of relationship between CSP and CFP and the specific contributions of the various stakeholder groups (employees, environment, community and diversity). The results of this study could help managers with respect to the management of the various contradictory stakeholder goals in order to successfully undertake CSR activities, which will result in enhanced CFP. Furthermore, before developing specific CSR strategies, managers may use the results from this study to determine the appropriate allocation of its firm’s CSR resources to specific CSR

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6 activities – with respect to specific stakeholders that will be aimed to serve with CSR activities – based on the consequential impact of these activities on CFP. It will also answer the question which CSR kind of investments that (in)directly flow to or aim to serve the various stakeholder groups, are rewarded through an improved CFP. This thesis combines stakeholder theory, CSP, CFP and the possible mediating effect of reputation. Therefore, in line with the view that reaping benefits from CSP is a return from reputation (Fombrun, 1996), managers must learn to be attentive towards the perceptions of stakeholders, measured by the firm’s reputation. This thesis will also provide managers with the necessary insight that CSP and CSR expenditures form an appropriate tool to build a diverse set of intangible, hard-to-imitate and therefore valuable assets. This includes the development of the corporate reputation, which could be a source of competitive advantage and will consequently influence CFP. Although Neville et al. (2005) theorize about the link between CSP and CFP through reputation effects, they indicate future research with regard to the empirical examination of their propositions. This thesis intends to examine the mediating effect of corporate reputation on the

CSP-CFP relationship. The first section of

this thesis contains a literature review that elaborates on the concepts of CSR, CSP, CFP, (instrumental) stakeholder theory and the interrelatedness of given theories. Hereafter, the hypotheses will be derived from the theory in the theoretical framework section. The methodology section consist of a discussion on the methods, sample, variables and data, followed by a results section that provides for a description of the statistics and the empirical analysis. This thesis concludes with a discussion and conclusion section.

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II. Literature review

1. Neoclassical perspective

In recent years, where CSR has been characterized as an “almost universal practice” (Dressel, 2003: 1) many customers, employees, governments, community groups, suppliers and even shareholders still encourage firms to undertake investments in CSR. The concept of CSR has been widely studied and is merely divided into the ethical debate on and the business case for CSR. The ethical debate was launched by Friedman (1970) through its view that corporations are inappropriate and inefficient agents of social change, inevitably leading to the conclusion that any voluntary social contributions or CSR expenditures are misappropriations of shareholders’ funds. Therefore, firms should not engage in voluntary contributions to social causes. The business case for CSR focuses on the relationship between CSR investments and CFP. The core of the argument against the business case for CSR builds on neoclassical theory, which implies that resources used for CSR are at better use returning them to shareholders or improving the efficiency of the firm (Friedman, 1970). In this view, CSR investments represent an agency loss that deliver personal gains to the firm’s managers, but not to its shareholders (Barnett, 2007).

2. Stakeholder perspective

Contrary to this neoclassical view, the stakeholder theory of the firm (Freeman, 1984) stresses the importance of the relationships of firms with a broad set of individuals and organizations, or stakeholders, when allocating its resources. Stakeholders may be defined as “any group or individual who can affect or are affected by the achievement of the organization’s objectives” (Freeman, 1984: 46). The set of stakeholder groups are often divided into primary and secondary stakeholders (Clarkson, 1995). Primary stakeholders are essential for the survival of the firm, since firms have a direct and reciprocal exchange relationship with these groups (Van Der Laan et al., 2008). This group generally consists of employees, governments, communities, suppliers, customers and employees. Secondary stakeholders, which are not essential for the firm’s survival because they only try to

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8 influence the aforementioned exchange relationship, are represented by institutions, such as special interest groups (Godfrey et al., 2009). The identification of the various stakeholder relationships of firms helps determining which parties require attention from management, resulting into an optimization of relationships, while preserving the corporate legitimacy (Doh & Guay, 2006).

Instrumental stakeholder theory, as identified by among others Clarkson (1995), Cornell & Shapiro (1987) and Mitchell et al. (1997), even takes the aforementioned further by stating that CSR is indisputably related to CFP, since the satisfaction of various stakeholder groups is instrumental for organizational financial performance (Donaldson & Preston 1995). The instrumental part of stakeholder theory is reflected by the rewards of stakeholders in terms of reputation effects that may be derived from building honest, ethical and trusting relationships with organizational stakeholders (Jones, 1995). Waddock & Graves (1997) also emphasize the importance of instrumental stakeholder theory for CSP by stressing that high CSP yields goodwill from stakeholders, which leads to improved CFP. In line with instrumental stakeholder theory, the concept of stakeholder management emerged as an understanding of the strategic posture of firms with regard to their corporate social environment (Freeman & Gilbert, 1988). According to Wood (2010), stakeholder management consists of constructive and active engagement in relationships with the firm’s stakeholders, resulting into the development of assets that can be a source of competitive advantage (Branco & Rodrigues, 2006), causing an improved financial performance (Hillman & Keim, 2001). Further, firms acknowledge that stakeholder management is important, due to the fact that the satisfaction of demands of stakeholders is an unavoidable cost of doing business (Ruf et al., 2001) and could range from cost minimizing to societal maximizing (Freeman, 1984). Consequently, the stakeholder theory of the firm considers CSR expenditures as a tool to enhance a firm’s FP.

While the neoclassical perspective and stakeholder perspective lead to different conclusions with regard to the business case of CSR, Jensen (2002) – whose agency theory forms the foundation of the neoclassical view that considers CSR expenditures as an agency loss (Jensen & Meckling, 1976) –acknowledges that stakeholder management is essential in creating value for the firm in the long run, while the

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9 maximization of firm value also enhances long term social welfare. Therefore, it seems that there is somewhat of reconciliation between the two different perspectives.

3. What is CSR?

Although the concept of CSR is regarded as a contemporary theme, it emerged a long time ago. According to Hardin (1982), the importance of CSR was already acknowledged by Quakers in the early 1700s through their corporate slogan ‘came to do good and they did well’. While CSR has gotten more important ever since, there is still a lot of discussion about what actually may considered to be CSR in general (McWilliams & Siegel, 2001).

Bowen (1953: 6) was the first to establish a definition of CSR, by stating that “it refers to the obligation of businessmen to pursue those policies, to make those decisions, or to follow those lines of action which are desirable in terms of the objectives and values of our society.” Hereafter, more and more elements were included in the definition, which gave rise to different interpretations of the concept and ultimately even led to spin-offs, such as corporate sustainability, business (social) responsibility, corporate citizenship, corporate responsibility and the ethical corporation (Montiel, 2008). Hence, there are many different explanations with regard to the concept of CSR. For example, Davis (1973: 312) offers a definition of CSR by describing it as "the firm's consideration of, and response to, issues beyond the narrow economic, technical, and legal requirements of the firm... (to) accomplish social benefits along with the traditional economic gains which the firm seeks." According to Aguinis (2011: 855) CSR may also be regarded as the “context-specific organizational actions and policies that take into account stakeholders’ expectations and the triple bottom line of economic, social, and environmental performance.” In order to organize the diverse set of definitions, Crane (2008) divides the construct into the core characteristics of CSR, which are its voluntariness, the internalization and management of externalities, its focus on multiple stakeholder orientation, the alignment of social and economic responsibilities and the fact that it goes beyond philanthropy. The primary conception is that firms engage in CSR due to normative reasons and financial incentives such

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10 as improved management, product quality, efficiency and diversity within firms (Aguinis & Glavas, 2012). Wood (1991) emphasizes that CSR can be analyzed at three distinctive levels, namely at individual, organizational and institutional level.

Moreover, the concept of CSR has been divided by the academic literature into three different constructs: corporate social responsibility (CSR, or CSR1), corporate social responsiveness (CSR2) and corporate social performance (CSP) (Van Der Laan et al., 2008). The latter construct will be described in the following paragraph. The former concepts respectively refer to the business principles that guide managerial decision making and the processes through which firms respond to social demands (Frederick, 1987, 1994). Comprehensive research of Dahlsrud (2008), who analyzes 37 definitions of CSR that were laid down in academic papers between 1980 and 2003, indicates that this broad set of definitions fits within five dimensions, namely the economic, environmental, stakeholder, social and voluntariness dimension. Consequently, the lack of the existence of a universal definition of CSR does not deliver any problems when analyzing the concept of CSR. For the purpose of this thesis, the concept of CSR will generally be regarded as the firm’s voluntary actions to fulfill the interests of stakeholders in the social, environmental and economic domain.

4. What is CSP?

When investigating the relationship between CSP and CFP, CSP is often used as a synonym for CSR (McWilliams et al., 2006). Nevertheless, the concept of CSR is not widely accepted to be identical to the construct of CSP.Barnett (2007) argues that CSR and CSP are often unjustifiably regarded to be interchangeable, considering that CSP is a snapshot of the firm’s social performance at a given point in time, while CSR investments may change the specific state of a firm’s CSP. However, Orlitzky et

al. (2003) argue that the construct of CSP is yet still able to capture a major element of CSR.

Wood defines (1991: 693) CSP as “a business organization’s configuration of principles of social responsibility, processes of social responsiveness, and policies, programs, and observable outcomes as they relate to the firm’s societal relationships.” Building on the importance of stakeholders with regard to CSR – since they are the ones that set the norm for CSR, define the ethical

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11 issues, experience the effects of it and evaluate the behavior of firms – the ‘policies, programs’-part of this definition was redefined by Wood & Jones (1995: 230) as “internal stakeholder effects, external stakeholder effects, and external institutional effects.” According to Carroll (1979) CSP is a multidimensional construct that ought to be divided into four components: legal responsibility to the law or the government, economic responsibility to consumers and investors, ethical responsibilities to society and discretionary responsibility to the community. In general, CSP is seen as a broad construct consisting of stakeholder management and social issue management (Clarkson 1995; Swanson, 1995; Wood, 1991). CSP is thus significantly related to stakeholder management, although both definitions may not be considered to be synonymous (Clarkson, 1995). Unless the diverse efforts that have been made to distinguish the concepts of CSP and CSR, the academic literature often uses both definitions interchangeably (Margolis et al., 2007).

For the purpose of this thesis, CSP may considered as the outcome of the firm’s CSR actions. CSR expenditures therefore differ the level of the firm’s CSP in time, which is to a high extent in line with Barnett (2007). Moreover, CSP should not be seen as more than a broad construct that is additional to CSR and is certainly not related to CSR in any other way than resulting from CSR expenditures. This leads to the conception that CSP refers to the degree in which a firm successfully implements the interests of its stakeholders in view of the environment, community, employee relations and diversity.

5. Previous studies and research gap

There are basically two types of empirical studies that dive into the CSP-CFP relationship, namely one set of research that assesses the short term CFP – such as abnormal returns – of CSP, while the other examines the effect of CSP on long term CFP, which is measured by accounting or market-based measures of profitability (McWilliams & Siegel, 2000). This thesis will focus on the latter relationship. However, with regard to this relationship there is a lot of contradictory research, both theoretically and empirically. There are empirical studies with evidence of both a negative relation (Aupperle et al., 1985; Vance, 1975; Wright & Ferris, 1997), no relation (McWilliams & Siegel, 2000; Surroca et al., 2010) and a positive relation (Consolandi et al., 2009; Orlitzky et al., 2003) between

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12 CSP and CFP. Consequently, there is an impression that “in the aggregate, results are inconclusive” (Wicks et al., 1999: 212), due to a lack of appropriate theoretical foundations (Ullmann, 1985) and the “conceptual, operationalization, and methodological differences in the definitions of social and financial performance” (Griffin & Mahon, 1997: 6), but also because of stakeholder mismatching (Wood & Jones, 1995). Stakeholder mismatching is a measurement problem that results from the tendency of research to select a single item as proxy for CSP, which mostly represents only one group of stakeholders (Waddock et al., 2010).

In light of this stakeholder mismatching and the problem of using different definitions of CSP and CFP, Hillman & Keim (2001) decouple CSP into stakeholder management and social issue participation. They found a positive effect of stakeholder management and CFP, while finding a negative effect of social issue participation and CFP. Whereas stakeholder management is concerned with building better relations with primary stakeholders, such as employees, communities, suppliers and customers (Wood, 2010), this type of CSP could enhance CFP by the development of valuable and intangible assets – resources and capabilities – that can be a source of competitive advantage (Branco & Rodrigues, 2006). Accordingly, effective stakeholder management may lead to improved financial performance (Hillman & Keim, 2001). On the contrary, merely allocating a firm’s CSR resources to social issues is considered as an activity that can easily be copied by competitors, thus not resulting into an improved competitive advantage and ultimately not contributing to the firm’s financial performance. Consequently, assigning CSR expenditures to stakeholder management causes financial benefits while CSR expenditures to social issues participation do not. However, when disentangling stakeholder management into product, environment, employee relations, diversity and community, Hillman & Keim (2001) are unable to find significant results for every single dimension or specific stakeholder group within the concept of stakeholder management and are therefore indicating a promise for further research in this area.

While Hillman & Keim (2001) only investigate the different effects of stakeholder management and social issue management, this thesis intends to focus on further disentangling the various primary stakeholders that are included in the stakeholder management perspective and contribute to the financial performance of firms. Bird et al. (2007) also

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13 identify these five distinct CSR activities and investigate to which extent these activities contribute to CFP. However, they only use market based measures of CFP, which is not in line with the widely acknowledged conception that the inconclusive findings with regard to the CSP-CFP relationship are due to “conceptual, operationalization, and methodological differences in the definitions of social and financial performance” (Griffin & Mahon, 1997). Therefore, this thesis will use both accounting-based and market-based financial performance measures. Moreover, instrumental stakeholder theory derives reputational effects from building relationships with stakeholders (Jones, 1995) and this type of CSP leads to the development of intangible assets, such as corporate reputation, that may form the source of sustained competitive advantage (Branco & Rodrigues, 2006). Therefore, it seems that the concepts of stakeholder theory, CSP and CFP are related to the reputation of firms. Furthermore, instrumental stakeholder theory (Clarkson, 1995) implies that stakeholder satisfaction (Strong et al., 2001) enables firms to build valuable and intangible resources, such as reputations, which empowers them to acquire competitive advantage over their rivals (Orlitzky et al., 2003; Sharma & Vredenburg, 1998). While the mediating effect of reputation on the CSP-CFP relationship is assumed in the academic literature, this is merely represented by theoretical rather than empirical research. In addition, Roberts & Dowling (2002) empirically investigate the relationship between reputation and CFP, but indicate that there are important stakeholder groups, whose assessments are important in an analysis that focuses on the financial performance of corporations (Zuckerman, 1999). They stress the need for future research that examines the relationship between CFP and the reputation of the firm in the eyes of these stakeholders groups (Roberts & Dowling, 2002). Empirical analysis of Orlitzky et al. (2003) demonstrates that the relationship between CSP and CFP is positive because of contingencies, such as reputation effects, but emphasize the need for further inquiry with regard to CSP, reputation measures and market-based CFP, which will be done within this thesis. Consequently, previous studies demand further research with respect to the possible mediating effects of reputation on the relationship between CSP and CFP. Summarizing, the previous studies of the CSP-CFP relationship suffer from material empirical and theoretical limitations. This leaves room for skepticism and confusion with regard to the effect of CSR expenditures on CFP (Margolis & Walsh, 2003). Moreover, the concepts of CSR and stakeholder theory are considered as fundamental to the study of business and society

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14 (Maron, 2006), the inconsistency in the results of studies are of concern (Griffin & Mahon, 1997; Maron, 2006; Wu, 2006) and demand more investigation (Beurden & Gössling, 2008). Consequently, the aforementioned shortcomings and the ambiguous results of empirical studies require further empirical research. This study dives into the named relationship by constructing CSP as the firm’s capability of managing the various stakeholders groups (environment, employees, diversity and community) that consequently influences its corporate financial performance measured – contrary to previous studies – by both accounting- as market-based measures. While previous research only investigates the different effects of stakeholder management and social issue management, this thesis intends to further disentangle the various primary stakeholders that are included in the stakeholder management perspective and contribute to CFP. Linking instrumental stakeholder theory (Clarkson, 1995) and stakeholder management (Wood, 2010) to the concept of CSP, the CSP of firms may be regarded as a construct – that will be defined in the following section – that measures the capability of firms to effectively manage their stakeholders; or in other words, attain concerns towards the various stakeholder groups that are relevant for CFP. Therefore, the research question of this study is the following:

How does the capability of firms to manage the various stakeholders, such as employees, environment, community and diversity, which is reflected by their CSP, influence the CFP and what is the mediating effect of the firms’ reputation on the CSP-CFP relationship?

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III. Theoretical Framework

1. Individual effect of stakeholder groups on CFP

Building on instrumental stakeholder theory (Jones, 1995), one could argue that firms with high CSP may derive financial benefits from the positive interaction with their stakeholders. Dividing the various stakeholders in different groups enables firms to target their CSR expenditures and activities to stakeholder groups that are most relevant for CFP, resulting into in higher overall CFP (Waddock & Graves, 1997). Consequently, there is a need to identify and map the relevant stakeholders in order to foster the development of organization’s ability to identify particular efforts and link expected outcomes directly to the firm’s stakeholders. (Mitchell et al., 1997).

The concept of stakeholder power (Artiach et al., 2010) describes the relative power of stakeholders towards the firm and is found to be positively related to CSP (Ullman, 1985). For instance, if specific stakeholders control resources that are critical to the firm, it is more likely that the firm will respond to demands of these stakeholders (Artiach et al., 2010). On the other hand, stakeholders with little power over the firm are very unlikely to be targeted by the firm’s CSR activities. Stakeholder power can be determined by the amount of influence the stakeholders in particular have on the company’s CFP (Falck & Heblich, 2007). Furthermore, the concept of stakeholder salience, which may considered as the extent to which managers give priority to competitive claims of various stakeholders, is important (Mitchell et al., 1997). The degree of stakeholder salience is derived from the stakeholder power, legitimacy and urgency, as these attributes are perceived by the firm’s management (Mitchell et al., 1987). Thus, the stakeholder interests that do

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16 not seem to be directly tied to the firm’s CFP, could be prioritized differently from stakeholder’s interests from groups with high stakeholder power (Dooley & Lerner, 1994). Therefore, before constructing CSP as a capability of a firm to manage its stakeholders, this section will analyze the contributions of the relevant stakeholders groups that will be used in the CSP measure (employees, environment, community and diversity) to the financial performance of firms.

1.1 Employees

The first stakeholder group to be analyzed are the employees. According to Van der Laan et al. (2008), a high level of CSP leads to increased employee engagement, a higher level of employee’ identification with the firm and more attractiveness of the firm for prospective employees. In addition, strengthening the relationships with employees may facilitate productivity, decrease strife and decrease turnover (Barnett & Salomon, 2006). Linking to (instrumental) stakeholder theory, the development of more trusting relations with employees causes a higher level of retention and lower labor costs (Greening & Turban, 2000), while making the firm more attractive to potential employees (Turban & Greening, 1997). Hence, firms can benefit from paying attention towards the employee stakeholder group. If the employees identify themselves with their firm, they are more likely to socially interact within the organization, cooperate with other employees and act more competitive towards outsiders (Dutton et al., 1994). By contrast, if firms fail to take employee relations into account, for example when firms “violate the norms embraced by a stakeholder community” (Maignan & Ferrell, 2004: 14) employees will consequently be more likely to withhold effort (Kidwell & Bennett, 1994), which may negatively influence the companies’ FP.

1.2 Environment

Secondly, CSR expenditures that aim to achieve a higher level of environmental CSP seem to benefit CFP since there are opportunities for enhancing profits and increasing competitive advantage through

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17 the engagement in environmental strategies (Reinhardt, 1999). These economic benefits can be realized through the signaling of environmental quality of products by customers, regulators and other stakeholders that are interested in environmental issues (de Boer, 2003; Riley, 2001). On the contrary, firms with a low level of environmental CSP could face consumer disfavor, poor coverage in the media, degradation of their reputation and protests by activist groups (Fombrun et al., 2000), while also having higher risks of industrial accidents that may result in fines, lawsuits or even shutdown of its operations (Barnett & Salomon, 2006), ultimately leading to lower financial benefits. There is a wide range of research available that empirically supports the positive relationship between a firm’s environmental performance and CFP (Diltz, 1995; Konar & Cohen, 2001; Khanna & Damon, 1999; Blank & Carty, 2005). Due to the aforementioned, it is expected that environmental CSR expenditures will lead to economic benefits.

1.3 Community

Thirdly, firms can reap benefits from the engagement in community stakeholder relationships. Customers may feel more attached towards firms that have good relations with the community, rewarding this through an increased demand or the willingness to pay a premium for the products of such firms (McWilliams & Siegel, 2000). Moreover, the local community rewards firms that engage into community CSR activities with more favorable terms with regard to the use of the local infrastructure (Fombrun, 1996), while it could also provide for fast-track project approvals (Peloza, 2009). According to Waddock & Graves (1997), this community involvement also leads to a higher chance of stipulating favorable taxation and regulation deals with local government officials. In addition, it is beneficial to firms to build community ties and become socially integrated within the host community (Fombrun et al., 2000). Firms may further strengthen their local reputation within the community, which results in being better able to attract capital and trading partners (Branco & Rodrigues, 2006). Thus, it seems that the enforcement of the firm’s ties with the community, increases the demand and price of their products, establishes favorable circumstances and decreases the corporate operating costs, which in the long term all cause a higher level of CFP (Waddock & Smith, 2000). Multiple empirical studies support the relationship between the firm’s positive relations with

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18 their local communities and improved CFP (Hillman & Keim, 2001; Preston & O’Bannon, 1997; Waddock & Graves 2000).

On the contrary, firms that do not seem to respond to community demands, for example by breaching community norms and regulations, can be punished by market participants (Bird et al., 2007). When the level of community relations is considered to be low, it is likely that ‘not-in-my-back-yard’ (NIMBY) protests will arise when the firm attempts to open multiple plants within the environment (Barnett & Salomon, 2006). Also, this could hinder the firm’s ability to obtain permits from the local governments and give rise to possible litigation expenses(Dear, 1992).

Within the community stakeholder group, it is possible that CSR expenditures regarding this stakeholder group can also affect other stakeholders, such as (potential) employees, suppliers and the government. In line with Porter & Kramer (2006), a symbiotic relationship between the firm’s success and the success of the community evolves, merely given its close linkage to the corporate reputation of organizations. The more closely a firm seems to be tied to the local community, the greater the opportunity will be to leverage the organization’s capabilities and resources, leading towards a higher level of CFP (Porter & Kramer, 2006).

1.4 Diversity

Attaining concern to diversity is reflected by the provision of employment opportunities for minorities, meeting demands of special interest groups and providing working conditions that meet the demands of minorities; while on the other hand factors as the non-representation of minorities in management positions or the existence of major controversies may represent a firm’s inability to pay attention toward diversity (Bird et al, 2007).

As with the community stakeholder groups, stakeholders who derive value from the firm’s efforts to involve in diversity issues, could also find their diversity values improved when firms try to enhance their environmental values (Janney & Gove, 2011). Diversity CSP is represented by the various stakeholder groups, such customers, employees, the community and suppliers (Hillman &

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19 Keim 2001). Regarding issues of the diversity stakeholder group, a firm should always strive to achieve a link between a diversity measure, such as an effort to increase the percentage of minorities groups within the company, and the reactions of stakeholders, such as a resulting increase in customer satisfaction or employee productivity (Habisch, 2003). When this connection is made, diversity may bring a richness of talents, ideas and skills within the firm’s environment, consequently establishing a higher level of CFP (Habisch, 2003). For example, integrating diversity into the composition of the firm’s board is considered as a main driver of value creation and growth through its impact on creativity, fairness and the ability to predict opportunities (Terjesen et al., 2009). Thus, the market rewards firms that are involved in the diversity stakeholder perspective (Bird et al., 2007).

The diversity group of stakeholders merely connects to the stakeholder management approach, because it focuses on the due regard of all the demands of critical stakeholders, but also stresses the importance of accountability to all the stakeholders (Jamali et al., 2008). Therefore, firms that engage in diversity activities are able to build strong relationships with their stakeholders in order to maintain long term relationships (Perrini et al., 2007). Hence, there is a positive relation between diversity CSP and profitability, represented by the rewards from the markets when firms engage in diversity activities and the punishments if firms fail to account for diversity CSP (Bird et al., 2007).

2. CSP as a capability

Taking the above-described concepts of neoclassical theory, (instrumental) stakeholder theory, CSR, CSP and CFP together, the widely researched and criticized relationship between CSP and CFP may be investigated more accurately. According to instrumental stakeholder theory there is a positive relationship between CFP and CSP, because the satisfaction of various stakeholder groups is instrumental to organizational financial performance (Donaldson & Preston 1995; Jones 1995). Building on theoretical elements from Freeman (1984) and Harrison et al. (2010) firms can thus benefit financially from attending concerns towards the creation of stakeholder value, instead of solely focusing on creating shareholder value. By balancing and addressing the wishes of multiple stakeholders groups, managers become better able to increase the efficiency of the organization’s

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20 adaption to external demands (Hill & Jones 1992; Jones, 1995). In line with this, Ruf et al. (2001) derive from Freeman (1984) that stakeholder theory can be complemented by both the Resource-Based View (RBV) (Wernerfelt, 1984; Barney, 1991) and Transaction Cost Economics (TCE) (Williamson, 1975, 1985). From the TCE perspective, the development of strong stakeholder relationships avoids or lowers the high transaction costs that normally result from more formalized contractual compliance mechanisms, such as union contracts and government regulation (Ruf et al., 2001). Within this perspective, the instrumental stakeholder theory (Jones, 1995) considers the firm as a nexus of contracts (Jensen & Meckling, 1976), which implies that firms may increase their profitability by minimizing the costs of contracting (Barnett & Salomon, 2006). These costs can thus be reduced by the development of trusting relationships with various stakeholders (Wicks et al., 1999). The instrumental part of stakeholder theory also connects to TCE through the rewards of stakeholders in terms of reputation effects that may be derived from building honest, ethical and trusting relationships with organizational stakeholders (Jones, 1995). Barnett & Salomon (2006) consider the engagement in CSR as one of the primary means through which an organization fosters and maintains these trusting stakeholder relationships. The RBV perspective regards CSR expenditures and activities that are aimed to serve stakeholder demands as a strategic investment, which through the development of additional hard-to-imitate skills ultimately can lead to competitive advantage (Russo & Fouts, 1997). Whereas stakeholder management is concerned with building better relations with primary stakeholders, such as employees, communities, suppliers and customers (Wood, 2010), this type of CSP may enhance CFP by the development of valuable and intangible assets – resources and capabilities – that could be a source of competitive advantage (Branco & Rodrigues, 2006). Therefore, effective stakeholder management leads to improved financial performance (Hillman & Keim, 2001). Improving the CSP of a firm may thus function as a corporate tool to differentiate and achieve competitive advantage (Barney et al., 2007). Consequently, the enhancement of the level of CSP of firms results into higher CFP from either perspective, whether it is because of increased revenues or reduced costs. Both these perspectives, concerning the importance of building stakeholder relations and its effect of the relationship between CSP and CFP, are supported by empirical research (Hillman & Keim, 2001; Ruf, et al., 2001; Russo & Fouts, 1997). According to Wang & Choi (2010), the

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21 general idea is that a high level of CSP leads to better relationships with the stakeholders of the firm, which ultimately results into an increased CFP. Furthermore, it is suggested (Waddock & Graves, 1997) that the presence of positive relationships with stakeholders reduces the extent of difficulty when dealing with stakeholders such as customers, employees and the community. Hence, firms should focus on actively managing a broad range of CSP indicators (Funk, 2003). Since it is indisputably clear that engaging into relationships with stakeholders is not costless, firms are required to think about whether they have the capabilities to manage and allocate their CSR strategies and expenditures in a way that is financially beneficial. According to Wood (2010: 67), “stakeholder management practices are often used as surrogates for overall CSP, and sometimes studies are conducted to discover CSP implications of those practices on their own terms.” Hence, it may be argued that the construct of CSP is considered as a capability of firms to respond to stakeholders’ needs and consequently enhance the financial performance of organizations. Defining the CSP as a construct of the firm’s capability to manage its stakeholder relations very much resembles the concept of stakeholder influence capacity as identified by Barnett (2007). According to Barnett (2007), firms differ in their ability to use CSR to profitably improve their relationships with stakeholders, which also accounts for the heterogeneous results of the CSP-CFP studies. As with the construct of CSP as defined in this study, the stakeholder influence capacity of firms could be defined as the ability of firms to identify, act on and benefit financially from opportunities regarding the improvement of stakeholder relationships by means of CSR, not directly but indirectly affecting CFP through the firm’s influence or capabilities to manage its stakeholder relations.

Concluding, organizations that engage in CSP will be more likely to achieve a higher level of CFP (Freeman, 1984; Jones, 1995; Wicks et al., 1999). Building on instrumental stakeholder theory (Jones, 1995) and RBV (Barney, 1986, 1991) it is assumed that firms may grow intangible and inimitable resources, such as reputation, from the development of trusting relationships with their stakeholders (Surroca et al., 2010). This ultimately causes a more competitive and efficient use of the firm’s assets, which improves the capacity to attain competitive advantage (Orlitzky et al., 2003) and thus leads to a higher level of CFP. Moreover, assigning CSR expenditures to meet demands of stakeholders prevents firms from generating market fear, such as effects on corporate

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22 reputation, leading to a lower firm’s risk premium, which also increases the level of CFP (Cornell & Shapiro, 1987). Since firms differ in their ability to develop these intangibles and accordingly vary in reaping the benefits from their CSR activities, strategies and expenditures, it is argued that the construct of CSP may be regarded as a firm´s capability to respond to stakeholder’s needs and consequently enhance its financial performance.

Therefore, the following hypothesis is derived:

 H1: CSP – regarded as the capability of managing the firm’s stakeholders (employees,

environment, community and diversity) – is positively related to CFP.

3. Bidirectional relationship

When analyzing the relationship between CSP-CFP, it is often assumed that the amount of CSP influences CFP from a single direction. However, Hillman & Keim (2001) justly ask whether socially responsible strategies lead to financial benefits, or that CSP is simply a discretionary activity, which is funded by the slack availability of resources that arise from CFP. Waddock & Graves (1997) accordingly suggest that CFP and CFP are synergistic, meaning that CSP is a predictor as well as a consequence of CFP and hereby establishes a virtuous circle. This is derived from the proposition that firms with a high level of CFP are able to allocate more funds to CSP, but that CSP also enables them to reap more financial benefits (Surroca et al., 2010). Moreover, the combination of the theory of good (stakeholder) management (Donaldson & Preston, 1995; Jones, 1995) and the slack resources theory (Waddock & Graves, 1997) indicates a recursive relationship between CSP and CFP.

The slack resources theory (Waddock & Graves, 1997) assumes that a high level of CFP leads to a surplus of resources that provides firms with the funds to consider doing CSR expenditures (McGuire et al., 1988). When the CFP of a firm decreases, this might lead to less CSR expenditures, hence resulting to a lower level of CSP. Consequently, when firms have few resources to

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23 spend on CSR, it can thus be helpful to prioritize the stakeholders groups whose CSP investments are most effective with regard to enhancing CFP. The aforementioned gives rise to the idea that firms that face scarce resources need to prioritize the demands of the multiple stakeholder groups (Surroca et al., 2010). Ullman (1985) acknowledges that firms should generally prioritize economic demands over CSR expenditures in periods of low profitability. Moreover, stakeholder theory implies that when firms have very few resources, upper management may feel obliged to prioritize the demands within its broad set of stakeholders (Ullman, 1985). Therefore, the prioritization of stakeholders connects to the recursive relationship between CSP and CFP. Moreover, when CSP is defined in terms of stakeholder relationships and not in discretionary activities with regard to social actions, both social performance and good management become synonyms (Moneva et al., 2007).

In addition, according to McWilliams & Siegel (2000) there are certain intangibles, such as corporate reputation, that may be developed from building good relationships with stakeholders through the allocation of a high amount of funds to CSR. It has been empirically supported by Sharma & Vredenburg (1998) and is grounded by RBV logic (Surroca et al., 2010) that some firms respond to CSR demands from stakeholders by developing intangible resources that can become a source of competitive advantage. Fund arising from CFP could thus stimulate the development of such intangible resources if the company allocates these funds in order to improve its CSP at will of stakeholders, which in turn may again result in a higher level of CFP and establishes a recursive relationship (Shrivastava, 1995). This recursive relationship between CSP and CFP through the development of intangible resources such as corporate reputation, which will be elaborated on later, illustrates the chicken or the egg dilemma with regard to the CSP-CFP relationship.

Concluding, the relationship between CSP and CFP seems to be bidirectional (Waddock & Graves, 1997). The good (stakeholder) management theory suggests that social performance is positively correlated with stakeholder management because improved relationships with stakeholders can be achieved by engaging in CSP (Hillman & Keim, 2001), because CSP may be seen as an intangible assets that leads to a more effective use of resources and consequently positively influences CFP (Orlitzky et al., 2003). On the other hand, the theory of slack resources theory (Waddock & Graves, 1997) indicates that a surplus of resources provides firms

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24 with the necessary funds to consider allocating resources to CSR (McGuire et al., 1988). Hence, these different views are reconciled through the development of the virtuous circle relationship (Waddock & Graves, 1997). A broad meta-analysis of the CSP-CFP relationship literature by Orlitzky et al. (2003) affirms the idea of a recursive relationship between CSP and CFP, which provides evidence that both the good (stakeholder) management theory and slack resources descriptions are accurate (Surroca et

al., 2010).

Thus, I argue that:

 H2: The relationship between CSP and CFP is bidirectional. Hence, CFP is positively related

to CSP.

4. Reputation

According to Fombrun (1996: 72), the reputation of a firm may be defined as the “perceptual representation of a company’s past actions and future prospects that describe the firm’s overall appeal to all its key constituents when compared to other leading rival’s.” Weiss et al. (1999) extend this definition by regarding reputation as the perception of the extent to which a firm is held in high regard or self-esteem. This implies that a firm’s reputation is an organizational attribute that represents the extent to which stakeholders see the firm as ‘good’ or ‘bad’ (Roberts & Dowling, 2002). Consequently, one could argue that the instrumental stakeholder theory (Clarkson, 1995; Cornell & Shapiro, 1987; Mitchell et al., 1997) connects to the reputational effects on CFP, since the satisfaction of various stakeholder groups – which thus can be measured through corporate reputation – is instrumental for organizational financial performance. This is also reflected by the rewards of stakeholders in terms of reputation effects that may be derived from building honest, ethical and trusting relationships with organizational stakeholders (Jones, 1995).

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25 connected to the firm’s reputation, since the level of CSP has several external effects on the corporate reputation (Orlitzky et al., 2008). According to Fombrun & Shanley (1990) a firm’s communication with external parties regarding their level of CSP may help developing a positive reputation towards its stakeholders. This enhanced reputation also improves the relationships with its shareholders, which from instrumental stakeholder (Clarkson, 1995) perspective should lead to better performance. In addition, suppliers and customers (external stakeholders) could, due to moral convictions and value systems, become more willing to transact with companies with a high level of CSP (Orlitzky, 2008). However, McGuire et al. (1988) find that there are also internal reputational effects. Firms can become more attractive to employees and therefore attract better employees (Greening & Turban 2000) or improve the goodwill of its employees (Waddock & Graves 1997), resulting in higher CFP. The aforementioned internal and external effects may in aggregate explain an increase in CFP as a result of an improved CSP, mediated by the reputation of firms in views of important stakeholders.

Moreover, Surroca et al. (2010) draw upon the notion that instrumental stakeholder theory and RBV are linked in such matter, that the development of relationships with stakeholders enables a firm to develop certain intangible resources, such as human resources, culture, technology and reputation, which empowers firms to acquire competitive advantage over their rivals (Orlitzky et al., 2003; Sharma & Vredenburg, 1998). Therefore, Roberts & Dowling (2002) argue that these intangibles, including the reputation of firms, mediate the relationship between CSP and CFP. In addition, there are several other benefits arising from a good reputation of firms that may provide the rational for the relationship between CSP, corporate reputation and CFP (Fombrun, 1996). First, because the reputation of firms has an informational effect regarding the quality of the products or services of firms, consumers are willing to pay a premium for the products of firms that are held in high regard (Shapiro, 1983). Given the fact that employees prefer to work for firms with a good reputation and thus work harder or at lower costs, there is also a cost advantage arising from the firm’s reputation (Roberts & Dowling, 2002). This is also supported by the theory of TCE (Williamson, 1975), because suppliers will be less concerned about contracting with firms that are held in high esteem, as a result of the low contracting and monitoring costs. Since the judgment of stakeholders forms the foundation of reputation (Fombrun & Shanley, 1990), it is assumed that an

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26 increase in the level of CSP strengthens the reputation of firms through the augmentation of their corporate image (Rowley & Berman, 2000). Ultimately, a firm’s reputation is determined by signals received by stakeholders about its behavior (Brammer & Pavelin, 2006). If the corporate reputation is developed to such extent that the expectations and the firm’s behavior are aligned (Brammer & Pavelin, 2006), this will stimulate the building of trust between the firm and its stakeholders, resulting into stronger relationships and increased stakeholder satisfaction (Strong et al., 2001). The firm will accordingly build a strong reputation that ensures the continuing participation of the stakeholders, which forms the foundation for “the survival and continuing profitability of the corporation”

(Clarkson, 1995: 110). Concluding, the

concepts of stakeholder theory, CFP and CSP all connect to corporate reputation. When firms augment their reputation they will be better able to attract more and better employees (Turban & Greening, 1997), have a negotiating advantage with regard to capital suppliers and governments (Fombrun et al., 2000) and enhance the loyalty of customers (Rowley & Berman, 2000), which all lead to increased CFP (Fombrun & Shanley, 1990; Roberts & Dowling, 2002). Therefore, the corporate image of firms connects both to the CSP – in the sense of managing stakeholders – and CFP. Moreover, a positive reputation does not only cause extra resources and higher financial performance, it also mitigates the risks with regard to reputational losses that arise from the alienation of key stakeholders (Fombrun et

al., 2000). Cornell & Shapiro (2000) support this finding by stating that the failure to meet the

demands of stakeholders results into a decreased CFP, since this generates market fears that enhance the firm’s risk premium and affect FP accordingly. Finally, a high level of CSP may increase the financial performance of firms through the improvement of the corporate image in eyes of their stakeholders (Fombrun & Shanley, 1990). In addition, instrumental stakeholder theory (Clarkson, 1995) implies that stakeholder satisfaction (Strong et al., 2001) could enable the firm to develop intangible resources, such as reputations, which empowers firms to acquire competitive advantage over their rivals (Orlitzky et al., 2003; Sharma & Vredenburg, 1998). Therefore, it is expected that the intangible resource reputation mediates the relationship between CSP and CFP, which forms the basis of the third hypothesis:

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27  H3: The positive relationship between CSP – through the capability of managing its

stakeholders – and CFP is mediated by an improved reputation of firms in view of its stakeholders.

Building on the three hypotheses outlined in this section, the following conceptual model (Figure 1) could be drawn:

IV. Methodology

1. Sample

This thesis undertakes a panel data analysis of firms that were publicly listed at American stock exchanges between 2006 and 2012. The Wharton Research Database Service (WRDS) is used to investigate the companies that were selected through the choice of the reputational measure. Therefore, the selection of the specific indicator for reputation, which is derived from the Fortune 500 Most Admired Companies List, was crucial for the identification of the sample of this study. The Fortune 500 Most Admired list may be considered as a definitive report card on the reputation of firms and is composed by Hay Group. The composition of this index starts with a survey on the Fortune 1000 – the 1000 largest firms in the US by revenue – and the top foreign corporations that operate within the US. After this selection, the 10.000 directors, executives and analysts who responded to the first survey are asked to select the ten companies that they admire most. Respondents are free to

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28 choose any company they admire from any industry. Consequently, a total of 600 corporations from 70 different industries are selected each year.

Given this sample, the COMPUSTAT database is used to identify the various CFP indicators – return on assets, return on equity and market value-added – that are central in this study. This database from Standard & Poor’s is one of the most comprehensive databases of financial data about business available. Because the Fortune 500 reputation index merely selects American companies, the S&P COMPUSTAT North America database, which provides fundamental and market information on publicly held corporations and contains income statements and balance sheet date on over 10.000 organizations as of the 1950s, is considered as the most suitable database to collect data with respect to the CFP indicators.

In order to identify the indicators of CSP, the Kinder, Lydenberg and Domini (KLD) database that covers approximately 80 corporate social responsibility indicators within seven Qualitative Issue Areas including Corporate Governance, Diversity, Community, Employee Relations, Human rights, Environment and Product appears to be an appropriate tool. This database provides for annual snap-shots of the environmental, social and governance performance of corporations that are rated by KLD researchers. According to Sharfman (1996), this rating scheme has been tested for construct validity in relation to other measures of CSP and appears to be the best measure of CSP available. Furthermore, Waddock & Graves (1997) note that using KLD aggregates is the best operationalization of CSP one could select.

Given that the Fortune 500 index is comprised with data between 2006 and 2014, the data from COMPUSTAT is available since the 1950s and the KLD database started giving CSP ratings from 1990 and is as of writing updated until 2012, the timeframe of the 740 companies investigated is 2006 and 2012.

2. Method & Data Collection

Within this research the Pearson correlation and simple regression analysis are designated as the most appropriate method for investigating the relationship between CSP and CFP. The IBM SPSS program

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29 tests the data collected in the aforementioned databases. While the Pearson correlation identifies the extent and direction of the relationships, the regression analysis will help testing the hypotheses.

2.1 CFP indicators

Both accounting-based measures, such as return on equity (ROA) and return on equity (ROE), and market-based measures such as the market value-added (MVA), will be used to account for the CFP of the firms investigated.

To account for ROA, the net income of the firms is divided by their total assets (NI/AT). In order to get ROE, the net income of firms has to be divided by their total equity that is calculated by adding the preferred stock to the common equity (NI/(PSTK+CSHO). It is possible to obtain the market-value added (MVA) of each company by finding the sum of the market value of equity (item 199, price close (PRCC_F) x item 54, shares outstanding (CSHO)) + item 34, debt in current liabilities (DLC) + item 9, long-term debt (DLTT) + item 10, preferred- liquidation value (PSTKL), - item 35, deferred taxes and investment tax credit (TXDITC).

2.2 CSP indicator

The KLD database appears to be an appropriate tool to measure the CSP of named firms. This database evaluates firms based on sustainability criteria that have been measured since 1991 and are as of writing updated until 2012. Given that it contains widely available information with regard to firms publicly listed in the US, the database is able to provide information about almost every company within the sample. The KLD database covers approximately 80 indicators within seven Qualitative Issue Areas including Corporate Governance, Diversity, Community, Employee Relations, Human rights, Environment and Product. These qualitative issues represent the various stakeholder groups through several variables, which either indicate a positive or negative rating. Moreover, each qualitative issue also includes two variables that measure the total amount of strengths and concerns with regard to the specific corporate social responsibility indicator.

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30 – such as employees, the community and the environment – that within this study may considered as the CSP of firms, several variables from the KLD database seem viable. For example, the stakeholder group employees, can be measured by 21 different variables – e.g. employee involvement (as strength) or child labor (weakness) – within the qualitative issue area of employee relations. There are 24 variables available to identify the companies’ score on the environment, 14 regarding the community and 16 measuring diversity. However, each qualitative issue area also contains variables measuring the total count of strengths and weaknesses. These particular variables are indicated by the KLD database with the amount of strengths or weaknesses that are counted. When the company did not have a strength or concern with respect to the specific issue, KLD indicates this with a 0. Both variables about the strengths and weaknesses within the respective qualitative issue areas, which are employee relations, environment, community and diversity, are selected to measure the CSP of the firms investigated. The total score of the stakeholder capability of firms – CSP – is composed by subtracting the total concerns of a firm with regard to the environment, community, diversity and employee from the total number of strengths with respect to such issues.

2.3 Reputation indicator

The Fortune 500 Most Admired Companies List, which forms the basis of the reputational index within this study, is composed by a survey on a total of 611 corporations from 70 different industries each year. Consequently, a number of 740 organizations are selected by the respondents as admirable companies between 2006 and 2012. The list consists of two separate indexes, one for the top 20 most admired firms, the other regarding the top players within the several industries investigated. Moreover, the Fortune 500 database also publishes a full list of the firms that have scored in the top half of their sector, which is used in this thesis. Based on the industry surveys on executives and analysts, the Hay Group composes a company reputational score between 0 and 10, based on eight different components that represent corporate reputation. The scores of the companies used in the sample are deployed to investigate the mediating effect of the reputation of firms on the CSP-CFP relationship.

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2.4 Control variables

Furthermore, the academic literature advises to use three specific control variables when investigating the CSP-CFP relationship, since these moderators could control the relationship between CSP and CFP. Based on previous studies (Ullman, 1985; Waddock & Graves, 1997) a firm’s size seems to affect both CFP and a large part of CSP. Whereas larger firms have more diverse sets of resources (Barney, 1991), it is necessary to account for the differences in resources among firms. In addition, larger firms may exhibit higher CFP and thus engage in more CSR activities as they tend to have more slack resources to allocate to CSR investments (Orlitzky, 2008). According to Artiach et al. (2010) it is likely that size is an important determinant of CSP, because large firms attract greater attention from stakeholders, are more likely to influence the strategic responses to stakeholder demands and may also realize economies of scales with regard to their CSR expenditures. This thesis will include control variables for the size of firms in the analysis by controlling for net sales (SALE) and net income (NI) or the number of employees (EMP).

Moreover, according to McWilliams & Siegel (2000) one should always control for investment in Research and Development (R&D) when investigating the relationship between CSP and CFP. Griliches (1979) indicates that investment in R&D is an important determinant for financial performance, since investment in technical capital enhances the level of knowledge within the firm, which leads to product and process innovation and results in a higher CFP. Thus, omitting to control for R&D may ultimately flaw the empirical analysis with respect to the relationship between CSP and CFP. The investment in R&D is also derived from the WRDS database, by constructing the R&D intensity through dividing the R&D Expenditures (XRD) by the total sales (SALE) (R&D intensity = XRD/SALE).

Lastly, it is common to control for industry variables when investigating a sample of corporations that are active in different industries. Given that there presumably will be differences across industries, it is better to control for them. Waddock & Graves (1997) indicate there is indeed a need to control for industry when investigating the relationship between CSP and CFP. Consequently, the industry of the organizations within the sample are included

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32 as control variables in this study by using the standard 2-digit Standard Industrial Classification (SIC) code, ensuring that differences in the CFP measures (ROA, ROE, MVA) across the sample are not necessarily resulting from industry differences.

V. Results

1. Descriptive Statistics

Table 1 presents the descriptive statistics for the entire sample (n = 4846) and provides for the definition, mean, median, standard deviation, minimum and maximum of each of the variables.

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33 Within this sample that represents 740 mostly American based firms from ten different industries, the average firm has an ROA of about 0,5 percent per year, a market value added of 42.797 dollar and employs 60 individuals. While the minimum and maximum values for ROA and MVA are in line with expectations and could be representative for the companies investigated, the minimum value for ROE (-5.127.300 percent) and the maximum value (3.7666.000 percent) seem very exorbitant. Furthermore, the standard deviations of the ROE (135.186,053) and MVA (99.312,282) indicate an undesirably high spread. Accordingly, additional analysis is run to make these values more suitable for drawing conclusions. This was also illustrated by the problems of the financial indicators (ROA, ROE and MVA) while running the analyses, which seems to be due to the specificity of the data. In addition, the data looks very divergent, emphasized by the fact that some financial variables have very high values, whereas others show extremely low values. Therefore, CFP indicators seems not suitable for transformations as is usual in quantitative analysis, such as the transformation for normalization of the data. Thus, ROA, ROE and MVA are standardized in order to facilitate an appropriate data analysis. The standardization is used to fit all data to the same scale, which enables further experimentations and comparisons of standardized variables. This leads towards a more reliable assessment of the data with regard to the correlation, regression and mediation analysis.

Mean Median Std. Deviation Minimum Maximum

ROA 0,052 0,052 0,673 -0,902 46,455 ROE -2.695,387 -2.695,387 135.186,053 -5.127.300,000 3.776.000,000 MVA 42.786,916 42.786,916 99.312,282 -2.972,000 1.123.418,817 CSP 1,665 1,665 3,562 -7,000 18,000 CSP_Com 0,303 0,303 0,825 -2,000 4,000 CSP_Div 1,000 1,000 1,774 -3,000 7,000 CSP_Emp 0,011 0,011 1,450 -4,000 7,000 CSP_Env 0,351 0,351 1,269 -5,000 5,000 Reputation 6,207 6,207 1,016 1,500 9,050 Size 59,783 59,783 110,646 0,000 2.200,000 R_D 0,020 0,020 0,049 0,000 0,656 Descriptive Statistics TABLE 1

ROA is the return on assets; ROE is the return on equity; MVA is the market value; CSP is the corporate social

performance; CSP_Com is the CSP score on the community; CSP_Div is the CSP score on the diversity;

CSP_Emp is the CSP score on employees; CSP_enviroment is CSP score on the environment; Reputation is the

reputation index score; Size is the number of employees; R_D is the R&D intensity. n = 4907

The relationship between corporate social performance and corporate financial performance and the mediating effect of the reputation of firms

MASTER THESIS