The effect of ownership structure on the price earnings ratio - returns anomaly

- High insider ownership, returns decline (improve) for low (high) P/E firms.
- Can be explained by entrenchment and alignment of incentive effects
- For low P/E firms, poorly performing entrenched management cannot be influenced.
- For high P/E firms, high returns reflect incentives for value-creating managers.

It is well known that firms with low price to earnings ratios (value firms) earn higher stock returns in the long term than high price to earnings firms (growth firms). This study investigates how insider ownership affects this relation. We show that when insider ownership is high, returns decline for low P/E firms and improve for high P/E firms. These findings are rationalized in the context of entrenchment and alignment of incentive effects. For low P/E firms, low stock returns reflect the inability of boards of directors and outside shareholders to influence poorly performing entrenched management. For high P/E firms, boards of directors and outside shareholders are less likely to intervene since higher returns reflect increased agency incentives for value-creating managers.