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Institutional Ownership, Analyst Following, And Share Prices - Abstract

http://www.cfainstitute.org/learning/products/publications/dig/Pages/dig.v42.n4.71.aspx

Abstract

 

Institutional ownership and analyst coverage of stocks independently affect the share price and total value of firms. Firms value their stocks at various levels of pricing based on the anticipated benefits from institutional ownership, which, in turn, affects analyst coverage.


What's Inside?

The authors' primary objective is to determine the mutual relationships among institutional ownership, analyst coverage, stock market liquidity, and related share price levels. This research is useful specifically to investment practitioners because it offers explicit empirical evidence addressing the profound effect that institutional ownership and analyst coverage have on share price determination by firms. The authors also draw a distinction between the effects analyst coverage has on retail and on institutional investors.

How Is This Research Useful to Practitioners?

The uniqueness of this research is the authors' focus on the impact that institutional investors have on the stock price levels of firms through the monitoring and information-generation processes. They offer new insights into share price decisions for firms that propose to go public or intend to split shares.

The authors emphasize the impact of earlier research in understanding the causal relationship between stock price levels and information generation by brokers and other financial intermediaries. Financial intermediaries are incentivized by higher trading costs for investors, which subsequently results in higher revenues.

According to the authors, firms with private information should lower their share prices, which, in turn, will improve analyst coverage of the firms' stock and enhance firm value. Likewise, when a firm's share price level and information quality increase, the firm's institutional ownership and analyst coverage tend to decline. Also, firms that expect to benefit from institutional ownership will set higher share prices to reduce the cost of acquiring and owning shares of the firm.

How Did the Authors Conduct This Research?

The authors perform an empirical analysis by developing a model consisting of a sample of share price levels of firms (with CRSP codes 10 or 11) from 1985 to 2008. They include firms listed on the NYSE, Amex, and NASDAQ. The model considers a multistage economy with a combination of risky and riskless assets and two categories of investors: retail and institutional. The authors assume that all analysts are risk neutral, have identical abilities, and possess perfectly competitive capabilities.

They challenge and contradict earlier studies about the positive correlation between institutional ownership and analyst coverage of stocks. Earlier studies on this subject also excluded the possibility that information could be generated through sources other than financial intermediaries alone.

One of the key observations from previous studies is that as firms decide to increase the number of shares outstanding and then lower share prices, there is potential for an increase in cost to shareholders because of higher trading spreads. Existing empirical research has assumed that this increased cost dissuades an increase in institutional ownership, but the authors refute any direct connection between trading costs and ownership structure.

The authors link firm value measured by Tobin's q (ratio of the market value of assets to the replacement value) with such key factors as the firm's information quality, analyst forecasts, share price levels, and so on. The findings emphasize the authors' theory that firm value is positively correlated with the firm's information quality, precision of analyst information, and institutional ownership.

Abstractor's Viewpoint

The authors provide an improved perspective on the role and impact of institutional monitoring and information quality. Also, the findings are particularly emphatic in disproving such earlier notions as the existence of a positive correlation between analyst following and institutional ownership.

Although the analysis considers a reasonable time span (23 years) and a large universe of U.S.-listed firms, the main drawback in my opinion is the exclusion of diverse equity markets outside of the United States with lower equity market penetration, analyst coverage, and number of institutional investors. Also, these data exclude consideration of extreme black swan events, such as the financial crisis of 2008.

 

Summarized by Sridhar Balakrishna, CFA

CFA Digest November 2012, Vol. 42, No. 4: 82-84

(doi: 10.2469/dig.v42.n4.71)