It is under these assumptions that the entrepreneur maximises his share of after-theft cash flows (or dividends), and his benefits from expropriation. (La Porta et al, 2001) In countries with better shareholder protection, there is less expropriation of minority shareholders. Higher cash flow ownership by the entrepreneur is associated with less expropriation of minority shareholders. A Regression Model is used to analyse the relationship between valuation, investor protection, and ownership.
Hypotheses: other things equal: H1 - Firms in more protective legal regimes should have higher Tobin’s qs; H2 - Firms with higher cash flow ownership by the controlling entrepreneur should have higher Tobin’s qs; H3: Firms with better investment opportunities should have higher Tobin’s qs. H4: 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). Summary of Findings
In light of the research question and objective, the above model was used by La Porta et al (2001) to analyse data for the 539 firms and the following findings were arrived at: • Companies with controlling shareholders countries have higher valuations in common law than in civil law countries. • Incentives are associated with higher valuation when investor protection is poor • The benefits of cash flow ownership for valuation are higher in low investor protection countries. These results are consistent with the predictions of the theory concerning the effects of investor protection and entrepreneurial cash flow ownership on firm valuation.
They provide indirect evidence of expropriation of minority shareholders by controlling shareholders. Critique Having read through, and summarized La Porta et al’s paper on Investor Protection and Corporate Valuation, it is now time to do a personal appraisal of the whole study. First the topic has been carefully chosen as it falls within the authors’ core competences. Their solid academic background (Harvard and Chicago Universities) coupled with their years of practical experience in research and industry could yield nothing short of a masterpiece.
The paper begins with a problem definition and research objective that serve as a solid base for the rest of the study. I find the study particularly interesting and different from similar studies because most prior studies on Corporate Valuation and Investment dwell on the effects of investor protection on financial markets but La Porta et al are interested in actually knowing how different country laws affect investors and the corresponding impact on firm value. But first they have done an extensive review of related literature throughout most of the paper, as no Literature Review section exists.
Related theories developed by other authors are discussed and key conclusions and findings highlighted. The literature review formed a good theoretical framework throughout the study. The authors did make a good attempt to identify the knowledge gap from the literature review and this had to do with the legal investor protection effect on firm valuation. Much of the data collected is secondary data for firms selected only from wealthy economies. This is a limitation to the study and hence the findings cannot be generalized to include emerging and developing economies.
The authors however claim that their choice of wealthy nations is due to availability of data as most firms in these countries have websites from which significant amounts of data can be obtained. A quantitative approach is adopted in investigating this effect for the 539 selected firms. A simple and comprehensive model is developed to analyse the incentive effect of managerial cash flow. The equations clearly explain the relationship between the relevant variables making it easy to see how the controlling shareholder expropriation tendencies relate to costs of expropriation and degree of investor protection under different legal regimes.
The findings are consistent with theory and in support of the 4 hypotheses formulated under the model definition. Overall, the research question and objective of the study are met. The entire study is coherent with all the sections linked to each other. It provides a base for further research on legal investor protection and corporate valuation considering a wider time frame as the data used is only for one year on average. It will be interesting to replicate a study like this in developing and emerging markets.
The reliability and validity criteria of the study may have some significant loopholes given that certain parameters might have changed over time like local country investment laws, ownership structures of sampled firms while some firms might have closed down or subjected to takeovers and mergers.
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