Happy workers make good workers, all to the benefit of the firm and its shareholders.

That, at least, is the view on the progressive side of the management-theory spectrum. Others, of course, believe that employees work hardest under the crack of the whip and fear of unemployment. In the early 20th Century, some economists argued that high levels of employee satisfaction meant workers were overpaid or underworked.

But what does the data say?

New research by Wharton finance professor Alex Edmans and two colleagues shows that higher levels of job satisfaction among employees can indeed produce higher returns for a firm’s shareholders. But there’s an important caveat: The effect is much more pronounced in countries that have flexible labor policies, where hiring and firing is easier, than in heavily regulated economies.

“The countries with higher [stock] returns were the ones with more flexible labor markets,” Edmans says.

The findings are detailed in the paper “Employee Satisfaction, Labor Market Flexibility, and Stock Returns around the World,” co-authored by Lucius Li and Chendi Zhang, both of the University of Warwick. It builds upon previous sole-authored studies by Edmans which found that companies ranked among the 100 best to work for in the United States produced annual stock returns two to three percentage points higher than peers that were not on the list. But that was in the U.S.

“Most academic papers are focused on the U.S. — that’s where we have the best data,” Edmans notes. “But what’s true in the U.S. is not necessarily true for the rest of the world.” The new study looks at 14 countries with a variety of regulatory environments, producing a more nuanced picture of the value of employee satisfaction.

Value or Wasted Expense?

The role of satisfaction has changed over time. “For the typical 20th Century firm, the bulk of its value stemmed from its physical capital,” Edmans and his colleagues write. “In contrast, most modern firms’ key assets are their workers — not only senior management but rank-and-file employees. For example, in knowledge-based industries such as software, pharmaceuticals and financial services, non-managerial employees engage in product development and innovation, and build relationships with customers and suppliers, and mentor subordinates. Employee-friendly policies can attract high-quality workers to a firm and ensure that they remain within the firm, to form a source of sustainable competitive advantage.”

In old-fashioned firms, such as factories, employee output could be measured easily in units produced. Thus, there was little role for employee satisfaction in motivating workers. Instead, managers could motivate workers by counting the number of units they produced and paying for output. In the modern firm, key outputs are intangible, such as building client relationships. Since these outputs are harder to measure, pay-for-output is less effective, and so employee satisfaction is an increasingly valuable motivational tool.

Studying the effect of employee satisfaction on firm performance is particularly tricky because, even if you documented a positive relationship between these two variables, it’s not clear what causes what. It could indeed be that satisfied employees are more motivated and thus perform better. But it could be that well-performing firms can afford to spend money on employee-friendly initiatives. To address these concerns of reverse causality, Edmans and his colleagues studied the link between employee satisfaction today and future stock returns. In particular, if employee satisfaction were the result, rather than cause, of good performance, then a well-performing firm would already have a high stock price today, and so should not generate a superior return in the future, Edmans notes.

Since today’s outputs are harder to measure, employee satisfaction is an increasingly valuable motivational tool.

In the earlier work focusing on U.S. firms, Edmans found better stock performance among companies with worker-friendly policies. But in the U.S., the labor market is particularly flexible — hiring and firing is simple. Other countries, such as Germany, are much more restrictive.

For the new study, the researchers looked at 14 countries: Brazil, Canada, Chile, Denmark, Finland, France, Germany, Greece, India, Japan, Korea, Sweden, the United Kingdom and the United States. All were among the 45 nations with lists of the best companies to work for, produced by the Great Place to Work Institute in San Francisco. In choosing the best companies, the institute surveys employees at some 6,000 firms in 50 countries to gauge how much they trust the people they work for, and whether they take pride in what they do and enjoy the people around them. The surveys therefore rely on the employees’ own gauge of satisfaction rather than tallies of factors like pay and benefits.

Each of the 14 countries chosen had at least 10 publicly traded firms on the best-companies list, and all those countries also had data for labor market flexibility. One gauge of this was an index of employee-protection legislation by country; another was an index of economic freedom. The indexes incorporated factors such as laws protecting workers from dismissal, costs of dismissing workers, prevalence of collective bargaining, and rules for hiring temporary workers, such as requirements that pay and working conditions be the same as for full-time workers.

Overall, the new study confirmed the results Edmans had found earlier in the U.S.: Companies with high worker satisfaction generally produced alphas, or above-average stock returns, compared to their peers. In fact, the U.S. firms’ average monthly alpha of 22 basis points (or .22%) was just the 10th highest among the 14 countries, in periods roughly spanning 1998 to 2013, depending on when the best-companies data was available. Japan had a monthly alpha of 77 basis points, and the U.K. 81 basis points, though the researchers caution that the country-by-country breakdowns are imperfect because of small sample sizes. The 22 basis point monthly alpha in the U.S. means that if the peers’ stock rose 10% a year, the best companies’ shares would return 12.6%.

Flexibility Is Key

The benefits of employee satisfaction, however, were not universal. Germany had a negative alpha of 45 basis points, while Denmark was negative 63 and Greece negative 58. A statistical analysis showed the effect of high employee satisfaction was diminished in countries like these that had low labor-market flexibility.

“Overall, our results suggest that the association between employee satisfaction and stock returns depends critically on the institutional context,” the researchers write. The authors conclude that “being listed as a Best Company to Work For is associated with superior returns only in countries with high labor market flexibility.”

“The benefit of employee satisfaction is lower if you are less likely to recruit to begin with.” –Alex Edmans

Why is that? Put simply, says Edmans, it’s because satisfaction, which involves factors like job security and fair treatment, is already relatively high in the countries with lots of worker-friendly legislation. Thus, the benefits of even more employee satisfaction will be low, and may not justify the cost.

Generally, he says, high levels of satisfaction benefit firms in three ways: by improving worker recruitment, retention and motivation.

In countries like Germany that have lots of worker protections, workforces are comparatively stable — there’s not a lot of hiring and firing. “The benefit of employee satisfaction is lower if you are less likely to recruit to begin with,” Edmans explains, noting that there is less hiring when there are legal obstacles to firing. Similarly, high satisfaction has little impact on retention if workers are already not likely to leave. One of the motivational benefits of satisfaction is that employees will work particularly hard to avoid being fired from a satisfying job. This benefit is less valuable if workers don’t fear getting fired to begin with.

Two groups can benefit from this research, Edmans says: corporate managers and investors. Both should understand that policies that boost employee satisfaction can improve shareholder returns. But that works only to a certain point. Once satisfaction is high, due to the company’s policies or worker-friendly labor laws, the returns from further investment in satisfaction start to diminish.

A more nuanced implication is on the market’s valuation of intangible assets, such as employee satisfaction. The best companies lists are public and so the stock price should immediately react when these lists are published. However, the authors’ finding that investors can generate superior stock returns by trading on these lists after the fact suggests that the market is slow to react. Edmans concludes that “in order to encourage managers to invest in the intangible assets that are critical to a company’s long-term future, we must move away from evaluating them according to short-term stock price performance and instead give them shares and options that do not vest until the long-term.”