Investor Protection and Corporate Valuation
Published 18 Jan 2017
This paper aims to write a detailed summary and critique on the article entitled `Investor Protection and Corporate Valuation` from Journal of Finance. The paper talks about international issues and in particular country laws and how they affect financial markets and investor rights.
As a problem background and objective of the article, the then authors of the research work began with a discussion of the problem where the raised concerns as to how local laws can be used to influence the investment climate in a country. In the paper, they presumed investors to be risk averse and likely to invest in countries where there are sound laws in place to protect their investments from expropriation by controlling shareholders.
The authors have cited one study which has shown that protective local laws favours development of financial markets due to the fact that their knowledge that their rights are well protected by the law, investors, will be more willing to pay more for financial assets because of the higher potential returns involved. They cited however, specific factors from each country to account for differences in the pace with which financial markets are developing in different countries (La Porta et al, 2001)
The cited prior studies in La Porta et al’s paper have focused on the benefits of legal investor protection for financial development, left the question: “How are these protective investment laws impacting on firm value?” The authors therefore had such research question to investigate and provide explanations while bearing mindful of the fact of the difference that exist in ownership structures and control among firms within and across countries. This is because these differences affect the power and incentives of controlling shareholders to expropriate minority shareholders. (La Porta et al, 2001)
In developing the paper’s theoretical framework, the study has reviewed extensive literature on related studies while highlighting key conclusions. The topics discussed included “the incentive effect of managerial cash flow ownership, the central agency problems in large publicly traded firms, the effects of corporate ownership structures on valuation to the influence of law on corporate ownership structures, pidend policies, size of firms, the efficiency of investment allocation, economic growth and even the susceptibility of a country’s financial markets to crash.
The paper had also in its literature review on a range of issues such as the relationship between voting premium and valuation, the effect of managerial ownership on the profitability and valuation of U.S. firms, the effects of entrepreneurial control and cash flow ownership on the valuation of firms in many East Asian countries and the effects of bank ownership on the valuation of German firms.”
How the paper conducted the empirical analysis and definition of parameters?
The authors used the Tobin’s q, where they performed an empirical investigation of the effect of protective investor laws and ownership by controlling shareholders on firm value for 539 firms selected from 27 wealthy economies. They held both the power and the incentives to expropriate are held constant to allow then to better assess the effect of investor protection on corporate valuation (La Porta et al, 2001).
They also defined some key parameters for clarity and better interpretation of results and are summarized as follows (La Porta et al, 2001): (a) Indicators of shareholder protection – Origin of a country’s laws and the index of specific legal rules; (b) Incentive effects of ownership – Only companies that have controlling shareholders are considered here to keep the power to expropriate relatively low; and (c) Measure of Incentives – Cash flow ownership by the controlling shareholder.
As to model assumptions, La Porta et al (2001) had the following: (1) There is only one controlling shareholder; (2) This controlling shareholder has cash flow or equity ownership, Alpha, in the firm; (3) Alpha is exogenously determined by the history and the life-cycle of the firm, and do not consider the sale of equity by the entrepreneur; and (4) The entrepreneur is the manager
As to model specification, the authors had, among other, the following: (1) The firm has an amount of cash I, which it invests in a project with a rate of return R.; (2) The firm has no costs, so the profits are RI(the scale of investment does not matter); (3) The entrepreneur can pert a share, s of the profits from the firm to himself before distributing the rest as pidends. (persion that is not theft involves costs).
The authors used a Regression Model o analyze the relationship between valuation, investor protection, and ownership using the two hypotheses. First, other things equal, firms in more protective legal regimes should have higher Tobin’s qs; Second, firms with higher cash flow ownership by the controlling entrepreneur should have higher Tobin’s qs; Third, firms with better investment opportunities should have higher Tobin’s qs; and Fourth, for the quadratic cost-of-theft function, the effect of the entrepreneur’s cash flow ownership on valuation is lower in countries with good investor protection (La Porta et al, 2001).
La Porta et al (2001) arrived at the following summary of their findings involving 539 firms studied: (1) Companies with controlling shareholders countries have higher valuations in common law than in civil law countries; (2) Incentives are associated with higher valuation when investor protection is poor; and (3) The benefits of cash flow ownership for valuation are higher in low investor protection countries.
Consistency between the results of their study and the predictions of the theory on the effects of investor protection and entrepreneurial cash flow ownership on firm valuation was noted in addition to noted indirect evidence of expropriation of minority shareholders by controlling shareholders.
Without sounding too agreeable with authors, it could be fairly stated topic has been carefully chosen as it falls within the authors’ core competences. La Porta and co-authors had solid academic background (Harvard and Chicago Universities) coupled with their years of practical experience in research and industry which could produce nothing short of a masterpiece.
With the papers starting with a problem definition and research objective, to server as a solid base for the rest of the study, I found the study particularly interesting and distinct from similar studies since most prior studies on Corporate Valuation and Investment dwelt more on the effects of investor protection on financial markets but La Porta et al’s work exhibited profound interested in actually knowing how different country laws affect investors and the matching impact on firm value.
In addition, the literature review conducted by the authors was obviously extensive compared to previous works where there was absence of such review section. With the authors’ discussion of related theories they also discussed and highlighted the key conclusions and findings which in turn formed a good theoretical framework throughout the study (La Porta et. al., 2001). Having made a good attempt to identify the knowledge gap from the literature review, it was but interesting to note that and this had to do with the of effect legal investor protection on firm’s valuation.
With much of the data collected to be secondary data from various companies selected only from wealthy economies, such acknowledged limitation to the study warns that the findings cannot be generalized to include emerging and developing economies. The authors’ choice of wealthy nations was explained by them to be due to availability of data as most firms in identified countries have websites where significant amounts of data were obtained.
The authors also applied a quantitative approach in investigating this effect for the 539 selected firms. Under the approach, they developed a simple and comprehensive model to analyze the incentive effect of managerial cash flow (La Porta et. al., 2001). It could be said that the equations clearly explained the relationship between the relevant variables and this would make it easy to see how the domineering shareholder expropriation predispositions relate expropriation cost and level of investor protection under perse legal regimes.
The author’s findings could also be said to be consistent with theory and in support of the 4 hypotheses formulated under the model definition; hence obviously I believe that the article met purpose of the research question and objective of the study are met. I saw also coherence of the entire study all the sections relevantly linked to each other. The findings also provided a base for further research on legal investor protection and corporate valuation by may be employing a wider time frame of more than one year since as the data used appeared to cover only for one year on average. Moreover, it may sound challenging to repeat a study like this in developing and emerging markets and whether there is basis to conform to the results. The latter is however subject to availability of information.
It should me made clear however that the reliability and validity of conditions under which the study were prepared may have some significant loopholes given that certain factors might have changed over time. These factors include local country investment laws, ownership structures of sampled firms where some of these firms might have closed down or became part of takeovers and mergers.
To conclude, it could be stated that there is a difference between having the effect of better financial markets from having legal protected investors from bringing the effects into valuation to see a more direct result of legal protection. This work of La Porta et. al. has therefore brought knowledge into more practical level to held decision makers. The paper has however warned of limitation of the study thus decision makers must be well guided as to possible effects in their decisions. Having therefore brought said limitations, opportunities for deeper research on firms from emerging economies are now open for researchers.
La Porta R., Lopez-de-Silanes F., Shleifer A. and Vishny R (2001). Investor protection and corporate valuation. Revised, May Harvard University, Kennedy School of Government, Harvard University, and the University of Chicago