Investment Decisions, Price-Earnings Ratios and Finance: Evidence from Firm-Level Data

Abstract

Economic theory suggests that firm's investment depend on future growth opportunities, measured for example by price-earnings ratios, but might be dampened by inefficient financial markets. This paper tests these hypotheses using an unbalanced panel of 9,000 listed firms from 41 developed and developing markets, from 1990 to 2006. The empirical results confirm that managers use the information contained in the price-earnings ratios to make investment decisions. Moreover, stock market development and the specialization of the financial system towards arm's length instead of bank financing has a positive effect on firms' investment decisions. Taken together, these results suggest that firms with higher growth opportunities accumulate more capital and that the stock market has a key role in channelling funds toward investment projects. IntroductionAssessing the impact of growth opportunities on investment decisions and therefore, on economic growth, has been the focus of several contributions in the corporate finance literature (Fazzari et al. 1988;Chen, Goldstein and Jiang, 2006) as well as in the finance and growth literature (Rajan and Zingales, 1998;Wurgler, 2000; Fisman and Love, 2004 a,b;Bekaert et al., 2007). Moreover, two natural questions about the impact of financial institutions on investment have been addressed in the finance and growth literature. The first question is whether more efficient financial systems are likely to encourage investment decisions (Wurgler, 2000;Love, 2003;Ndikumana, 2005;Bekaert et al., 2007), while the second question is whether the financial specialization of a country toward the stock market or the banking activity plays a key role in investment decisions (DemirgucKunt and Maksimovic, 2002;Ndikumana, 2005;Ergungor, 2008).Even though the literature on corporate finance has focused on different price-based measures of firms' growth opportunities, such as the Tobin's Q, there is no evidence on the sensitivity of investment to the price-earnings ratios. On the other hand, the literature on finance and growth documents the existence of a positive influence going from growth opportunities to investment and therefore, to growth, but only using aggregate industrylevel and country-level data. For instance, the contribution by Bekaert et al. (2007) uses data on the price-earnings ratios at industry-level to assesses the link between country's growth opportunities and aggregate investment growth. Similarly, almost all contributions documenting the existence of a causal relationship between financial development, financial structure and investment use aggregate data (Wurgler, 2000;Ndikumana, 2005;Bekaert et al., 2007).The present work aims to contribute to this literature by testing three main hypotheses through a model that uses firm-level panel data obtained from a high-quality source: the Worldscope Database. The first hypothesis is that firm's future growth opportunities, measured by the price-earnings ratios, positively influence investment decisions, even after controlli...

The Investigation of the impact of the firm factors on stock returns of non-financial listed firms in kenya

“…Earnings are a function of investment decisions and operating efficiencies. Value of a firm depends upon earnings of a firm and its cost of capital (Pietrovito, 2012). Capital structure cannot affect the total earnings of a firm (EBIT), but it can affect the residual shareholders' earnings.…”