Tobin’s Q, Managerial Ownership, and Analyst Coverage
A Nonlinear Simultaneous Equations Model
Carl R. Chen and Thomas L. Steiner
This paper estimates a simultaneous equations model with analyst coverage, managerial ownership and firm valuation jointly determined within the system. We argue that both
managerial ownership serving an internal monitoring function and analyst coverage serving an external monitoring function enhance firm value, while managerial ownership
and analyst coverage are substitutes in the monitoring of the firm. The empirical results based upon a nonlinear three-stage-least-square procedure lead to several interesting
conclusions: First, we find a diminishing substitution effect between managerial owner- ship and analyst coverage and a decreasing marginal value for managerial ownership.
Second, we find support for both an alignment effect and an entrenchment effect in the relationship between managerial ownership and Tobin’s Q after controlling for the effect
of analyst coverage. Third, we find support for the argument that analyst coverage serves to enhance firm valuation after controlling for the effect of managerial ownership. Finally,
we find that analyst coverage, managerial ownership and firm valuation are jointly determined.
© 2000 Elsevier Science Inc. Keywords: Firm value; Managerial ownership; Analyst coverage
JEL classification: G30; G32
I. Introduction
This paper studies the joint determination of firm valuation, managerial ownership and analyst coverage. Specifically, we argue that both internal monitoring managerial own-
ership and external monitoring analyst coverage enhance firm value, although we find that firm value is retarded when managerial ownership exceeds 28.8. We also postulate
Professor of Finance, University of Dayton, Dayton, OH CRC and TLS. Address correspondence to: Carl R. Chen, Department of Finance, University of Dayton, 300 College Park,
Dayton, OH 45469-2251
Journal of Economics and Business 2000; 52:365–382 0148-6195 00 –see front matter
© 2000 Elsevier Science Inc., New York, New York PII S0148-61950000024-2
that higher firm value inspires higher managerial ownership, and invites more analyst coverage. Yet, while we argue that both managerial ownership and analyst coverage
increase firm value, we contend that they are substitutes for one another in monitoring the firm.
1
Firm Value and Monitoring
Jensen and Meckling 1976 make persuasive arguments that predicts managerial own- ership serves to align the interests of managers and outside equityholders such that a
positive relationship is expected between managerial ownership and firm valuation. Stulz 1988 develops a model of firm valuation in which entrenchment effects result in a
negative relationship between managerial ownership and firm valuation at a sufficiently high level of managerial ownership. Furthermore, Jensen and Meckling argue analyst
coverage to be a positive determinant of firm valuation. They state: “We would expect monitoring activities to become specialized to those institutions and individuals who
possess comparative advantages in these activities. One of the groups who seem to play a large role in these activities is composed of the security analysts . . . .”
2
They further argue that if “. . . security analysis activities reduce the agency costs associated with the
separation of ownership and control they are indeed socially productive. Moreover, if this is true we expect the major benefits of security analysis activity to be reflected in the
higher capitalized value of the ownership claims to corporations.”
3 4
Several empirical studies have used Tobin’s Q as a measure of valuation to study the relationship between managerial ownership and firm valuation. These papers include
Morck, Shleifer, and Vishny 1988 and McConnell and Servaes 1990 that offer support for both the positive alignment effect and the negative entrenchment effect. The empirical
models, however, do not account for the monitoring effects associated with analyst coverage. Chung and Jo 1996 fill this gap in the literature by empirically testing the
relationship between the number of analysts and Tobin’s Q and find a positive relation- ship. Their study, however, does not model the effect associated with the percentage of
managerial ownership. As a consequence of the incompleteness of these existing studies, it remains a vital issue as to the relationships between managerial ownership and firm
valuation and between analysts coverage and firm valuation after each effect is properly controlled within the same model.
Joint Determination
In an effort to formulate a proper empirical model of these relationships, we argue that analyst coverage, managerial ownership and Tobin’s Q are jointly determined and,
therefore, should be modeled within a three-equation system of equations. An argument
1
We use the terms “analyst coverage” and “number of analysts” interchangeably in the paper.
2
Jensen, M. and W. Meckling. 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3:354.
3
Jensen, M. and W. Meckling. 1976. Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of Financial Economics 3:355.
4
Similar causal arguments can be inferred based upon the research of Merton 1987 who argues for a positive relation between the level of awareness by investors investor cognizance of a stock and its valuation.
To the extent a higher number of analysts increase this investor cognizance, the number of analysts are expected to positively cause the level of firm valuation.
366 C. R. Chen and T. L. Steiner
for this empirical specification can be supported from a closer examination of earlier empirical research while this examination also allows us to gain additional insights into
the relationships between these variables. Chung and Jo 1996 jointly model Tobin’s Q and analyst coverage using a simulta-
neous equation estimation procedure. They argue that the amount of analyst coverage is a determinant of Tobin’s Q and Tobin’s Q is a determinant of the amount of analyst
coverage. Their empirical results are supportive of this joint dependency. Moyer, Chat- field, and Sisneros 1989 also model the amount of analyst coverage using a single
equation estimation procedure; they find this measure to be negatively impacted by the percentage of insider ownership. This finding suggests the possibility that the Chung and
Jo model should be expanded to include managerial ownership as an endogenous variable. Two points are relevant:
1. Moyer, Chatfield, and Sisneros contend that the relationship between managerial ownership and the number of analysts is consistent with a substitution effect which
they infer from the arguments of Jensen and Meckling 1976. Their empirical model, however, assumes a linear substitution effect. This linear effect, in turn,
implicitly assumes a constant marginal value for managerial ownership that is inconsistent with, for example, the observed entrenchment effects in the Tobin’s Q
literature [McConnell and Servaes 1990]. If the marginal value of managerial ownership diminishes, we may expect the causal inverse relationship from mana-
gerial ownership to analyst coverage to diminish.
2. The substitution effect argument made by Moyer, Chatfield, and Sisneros could similarly be applied to a causal relationship from analyst coverage to managerial
ownership. Indeed, it is possible that their results are spurious if they capture a relationship by which analyst coverage is a determinant of managerial ownership
rather than their hypothesized relationship by which managerial ownership is a determinant of analyst coverage. This counter argument is plausible because analyst
coverage mitigates the value of managerial ownership as an internal monitoring force. As a final point, the determinants of managerial ownership have been
investigated by Crutchley and Hansen 1989 and Jensen, Solberg, and Zorn 1992, yet these two studies have not explored the possible effect of analyst coverage on
managerial ownership.
Research Issues and Implications
The consequence of these prior theoretical arguments of Jensen and Meckling 1976 and Stulz 1988 together with the empirical results of Morck, Shleifer, and Vishny 1988,
Moyer, Chatfield, and Sisneros 1989, Crutchley and Hansen 1989, McConnell and Servaes 1990, Jensen, Solberg, and Zorn 1992, and Chung and Jo 1996 make a case
for the possibility that analyst coverage, managerial ownership and firm valuation are jointly determined. This endogeneity argument might be more simply represented by
Figure 1 in which selected theoretical and empirical research which are supportive of the relationships between the three endogenous variables are presented. The solid lines in the
figure represent causal relationships found in the existing literature that can be reexamined within our proposed system of equations. The dotted lines represent causal relationships
not previously examined in the existing literature, but hypothesized to be true by the current research. Therefore, our research objective in this paper is to expand this area of
Tobin’s Q, Managerial Ownership, and Analyst Coverage 367
the financial literature that has investigated the interactions among alternative monitoring agents and among monitoring agents and firm valuation. Our research design allows us to
more carefully examine the following questions:
● What is the relationship between managerial ownership and firm valuation after controlling for the effect of analyst coverage? What is the relationship between
analyst coverage and firm valuation after controlling for the effect of managerial ownership?
● What is the causal relationship between managerial ownership and analyst coverage? Is managerial ownership a determinant of analyst coverage? Is analyst coverage a
determinant of managerial ownership? Are these two monitoring functions substitute or complement?
● Are firm valuation, managerial ownership, and analyst coverage jointly determined? From the results of our empirical analysis, we offer a number of interesting conclu-
sions: 1. The level of managerial ownership is a nonlinear determinant of firm valuation and
analyst coverage is a positive determinant of firm valuation. At low levels of
Figure 1. The relationships between Tobin’s Q, managerial ownership and analyst coverage 368
C. R. Chen and T. L. Steiner
managerial ownership the relationship between managerial ownership and Tobin’s Q is positive in support of an alignment effect; at high levels of managerial
ownership the relationship is negative in support of an entrenchment effect. The findings are consistent with the arguments of Jensen and Meckling 1976 and Stulz
1988, and shed light on the empirical research of Morck, Shliefer and Vishny 1988, McConnell and Servaes 1990, and Chung, and Jo 1996 after both analyst
coverage and managerial ownership effects are included within the same model of valuation.
2. The percentage of managerial ownership is a nonlinear determinant of the number of equity analysts. We argue the result is explained by a diminishing substitution
effect and a diminishing marginal value for managerial ownership that becomes negative at a sufficiently high percentage of managerial ownership. The explanation
of this relationship runs parallel to the explanation for the causal relationship from managerial ownership to Tobin’s Q. Furthermore, the inflection point in the rela-
tionship between managerial ownership and analyst coverage is impressively close to the inflection point in the relationship between managerial ownership and Tobin’s
Q. This result serves to extend the empirical research of Moyer, Chatfield, and Sisneros 1989 and Chung and Jo 1996 by offering more insight into the
interaction between internal and external monitoring forces.
3. Analyst coverage is a negative determinant of managerial ownership. This result is consistent with a substitution effect and a diminishing marginal value to external
monitoring in the form of analyst coverage. The result serves to extend the empirical research of Crutchley and Hansen 1989 and Jensen, Solberg, and Zorn 1992,
which do not consider the impact of analyst coverage on managerial ownership.
4. Analyst coverage, managerial ownership and firm valuation are jointly determined. 5. Our conclusions are robust to the inclusion of institutional ownership effects and to
alternative methods for measuring the financial variables. The remainder of the paper is structured as follows: in Section II, the data, method-
ology, and testable hypotheses are presented; in Section III, the empirical results are reviewed; concluding remarks are made in Section IV.
II. Data, Methodology, and Testable Hypotheses
