Institutional Investors, Financial Health, and Equity Valuation

We investigate the relation between institutional ownership, financial health, and the market valuation weights on earnings and the book value of equity. We find that the valuation weight on earnings (book value) increases (decreases) with the level of institutional ownership for profit firms, while that on book value increases with the level of institutional ownership for loss firms. This valuation effect is not subsumed by incorporating current measures of financial health and is mainly driven by institutions with long investment horizons and monitoring incentives. We conclude that the institutional valuation effect is consistent with institutions playing a positive governance role.