Investor Protection Raises Company Share Values

"Better shareholder protection is associated with higher valuation of corporate assets and ...poor shareholder protection is penalized with lower valuations."

Statutory limits on the behavior of those in control of publicly traded companies appears to be good for share prices, according to a recent study by Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny. In situations where there are clear and strong legal limits on what is known as "expropriation" of earnings, investors are willing to pay a premium for securities. That means that investor protections, far from having a chilling effect, actually make companies worth a lot more than they would be without such restraints.

In Investor Protection and Corporate Valuation (NBER Working Paper No. 7403), the authors use data on 371 large firms located in 27 high income countries. Their basic finding is that "better shareholder protection is associated with higher valuation of corporate assets" and that "poor shareholder protection is penalized with lower valuations."

In effect, if you are an entrepreneur living in a country that places few barriers between you and your profits, the lack of restraint might be costing you money. The authors note that when investors are keenly aware that the law is not on their side, they're stingy in regards to share price; that deprives companies of capital and limits "the set of projects that can be financed."

The authors look at the fact that when individual "entrepreneurs" or small groups of shareholders control publicly traded companies--as is most often the case-- they have the authority to "divert a share of the profits" to themselves and then distribute what's left as dividends. According to the authors, a key determinant of whether those dividends are tantamount to a few crumbs or a fair slice of the pie is whether there are laws that at least make it difficult for controlling entities to feast on the profits.

While such laws are clearly a plus for minority shareholders and for the stability of financial markets, they have other benefits as well. It turns out that when investors feel their rights are secure, they reward companies by paying "more for financial assets such as equity and debt...They pay more because they recognize that, with better legal protection, more of the firm's profits would come back to them as interest or dividends as opposed to being expropriated by the entrepreneur who controls the firm," the authors assert. "By limiting expropriation, the law raises the price that securities fetch in the marketplace."

This gives companies the capital they need to take advantage of opportunities for expansion. The authors note that their study illuminates previous "findings that capital markets are broader and firms tend to be larger in countries with better investor protection." They also find that, aside from legal deterrents, the nature of people's financial stake in a company could give them a sort of self-interest incentive to distribute profits fairly. For example, entrepreneurs who depend on company stock to finance expansion--corporate acquisitions routinely substitute stock for cash--would not want to do something that would damage share price.

But while such dynamics might also produce fair treatment for minority shareholders and high valuations, the authors say that evidence of this more market-driven benefit is not as compelling as is proof of the positive effect of investor protection laws. Overall, the authors believe that demonstrating a clear link between investor protection and corporate health "expands our understanding of the role of investor protection in shaping corporate finance, by clarifying the roles which both the incentives and the law play in delivering value to outside shareholders."

-- Matthew Davis

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