Bridge over ocean
1 April 2016 CFA Institute Journal Review

Does Individual Investor Trading Impact Firm Valuation? (Digest Summary)

  1. Nitin Joshi

Individual investor trading can be shown to enhance firm performance. The authors show that individual investor trading helps improve firm value by reducing bid–ask spreads and increasing stock price informativeness.

What’s Inside?

The authors use retail trading data directly from the NYSE and examine the impact on firm value of individual investor trading in each stock aggregated on a daily basis. They conclude that individual investor trading leads to a reduction in bid–ask spreads and a reduction in information asymmetry, resulting in positive influence on the firm value.

How Is This Research Useful to Practitioners?

The participation of retail investors in the capital markets and the impact of that participation on firm valuation is of immense interest to investment professionals. The authors posit that at the aggregate level, trades by individual investors positively affect firm value. The positive effect of individual investor trading on firm value is stronger for good firms than for bad firms, and individual investor trading reduces information asymmetry and thus the spread. Finally, the positive effect of individual investor trading on firm value is stronger for stocks with a higher spread.

The authors use the market-to-book ratio (M/B) of equity to measure firm value. Individual investor trading is measured by using the individual trading volume ratio and individual trading turnover. Daily individual investor trading share volume and total trading volume are aggregated over each fiscal year for each firm. The individual trading volume ratio is the individual investor trading volume in a given stock divided by total trading volume for the same stock for a given fiscal year. Individual trading turnover is individual investor trading volume over the fiscal year divided by the number of shares outstanding at the beginning of the fiscal year.

The authors conclude that when individual investor trading is considered collectively, it provides more price informativeness and liquidity. Stock prices that are better reflectors of a firm’s financial condition help firms with efficient capital allocation, better resource management, and the retention of top talent, which results in better firm performance.

How Did the Authors Conduct This Research?

Data for the study are from the NYSE ReTrac EOD database from 15 March 2004 to 31 December 2011. The ReTrac database contains daily executed trades of all NYSE-listed stocks made by individual investors on the NYSE, and it summarizes the daily trading share volume and number of trades. Firm financial data are obtained from Compustat. Stock return, spread, and total trading volume data are from CRSP. Institutional ownership data are from Thomson Reuters Institutional Holdings (13F) Database, and analyst coverage data are sourced from I/B/E/S.

The authors examine the effect of individual investor trading, which they measure using the individual trading volume ratio and individual trading turnover, on the firm value, which is measured as the M/B of equity. They determine that daily aggregate individual investor trading has a significantly positive effect on the firm value. In addition, the effect is stronger for firms that have higher information production and a higher spread. Their findings are consistent across different market conditions and hold true for other firm valuation measures, including Tobin’s q and return on assets.

Abstractor’s Viewpoint

Although individual investors are generally viewed as uninformed noise traders, the authors conjecture that intense individual investor trading may enhance firm value by improving stock price informativeness. The authors prove that daily aggregate individual investor trading has a materially positive impact on firm value. It is an important study that highlights the significance of individual investors in capital markets.

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