Institutional Investors, Financial Health, and Equity Valuation

Abstract

This paper investigates the relation between institutional ownership, financial health, and the market valuation weights on earnings and book value of equity. We find that firms with high levels of institutional ownership are financially healthier, or less financially distressed, than firms with low levels of institutional ownership. More importantly, we find that the market valuation weight on earnings (book value of equity) increases (decreases) with the level of institutional ownership for profit firms. In contrast, the valuation weight on book value of equity increases with the level of institutional ownership for loss firms. Our findings of the above valuation effect of institutional ownership are consistent with two potential roles of institutions documented in prior literature: (1) institutions merely play a fiduciary role and (2) they play a positive governance role. Additional tests suggest that the level of institutional ownership appears to be an ex ante parsimonious proxy for both current and future financial health and that the valuation effect of institutional ownership cannot be subsumed by incorporating current measures of financial health. Moreover, we show that the valuation effect of institutional ownership is mainly driven by institutions with long investment horizons and monitoring incentives rather than institutions with short investment horizons and little monitoring incentives. We conclude that our findings of the valuation effect of institutional ownership are more consistent with institutions playing a positive governance role than merely playing a fiduciary role.

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