Investor Protection and Corporate Valuation

We present a model of the effects of legal protection of minority shareholders and of cash-f low ownership by a controlling shareholder on the valuation of firms. We then test this model using a sample of 539 large firms from 27 wealthy economies. Consistent with the model, we find evidence of higher valuation of firms in countries with better protection of minority shareholders and in firms with higher cashf low ownership by the controlling shareholder. RECENT RESEARCH SUGGESTS THAT THE EXTENT of legal protection of investors in a country is an important determinant of the development of its financial markets. Where laws are protective of outside investors and well enforced, investors are willing to finance firms, and financial markets are both broader and more valuable. In contrast, where laws are unprotective of investors, the development of financial markets is stunted. Moreover, systematic differences among countries in the structure of laws and their enforcement, such as the historical origin of their laws, account for the differences in financial development ~La Porta et al. ~1997, 1998!!. How does better protection of outside investors ~both shareholders and creditors! promote financial market development? When their rights are better protected by the law, outside investors are willing to pay 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. By limiting expropriation, the law raises the price that securities fetch in the marketplace. In turn, this enables more entrepreneurs to finance their investments externally, leading to the expansion of financial markets. Although the ultimate benefit of legal investor protection for financial development has now been well documented, the effect of protection on valuation has received less attention. In this paper, we present a theoretical and empirical analysis of this effect.

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