Legal Determinants of the Return on Equity

Recent work documents that better legal institutions are associated with broader equity markets. We investigate whether differences in legal institutions also help explain the international cross-section of expected stock returns. Three main regularities emerge. First, total stock market returns are positively correlated with overall measures of the quality of institutions, such as judicial efficiency and rule of law, controlling for risk. Second, dividend yields and earning-price ratios also correlate positively with judicial efficiency and rule of law, controlling for risk and expected earnings growth. Thirdly, equity returns have no relationship with the degree of protection of minority shareholders granted by the letter of the law. These findings suggest that equity markets are segmented, and that differences in monitoring, auditing and other enforcement costs are not the sole reason for segmentation. We interpret the positive cross-country correlation between the overall quality of the legal system and the expected return on equity as resulting from the curtailment of insiders’ private benefits and the increase of firms’ profitability associated with better institutions.