RETURNS TO EQUITY, INVESTMENT AND Q: EVIDENCE FROM THE UK

Abstract

Conventional wisdom has it that Tobin's Q cannot help explain aggregate investment. However, the standard linearized present-value asset price decomposition suggests that it should be able to predict other variables, such as stock returns. Using a new data set for the UK, we find that Q has strong predictive power for debt accumulation, stock returns and UK business investment. The correctly signed results on both returns and investment appear to be robust, and are supported by the commonly used and bootstrapped standard error corrections, as well as recently developed asymptotic corrections.

Inflation, human capital and Tobin's q

“…Figure 3 plots this low frequency q and in ‡ation relation over the sample period 1989:Q1 to 2009:Q4: 2 Given the closeness of the US and UK correlation coe¢ cient, the calibration is based on US data with the idea that the results may also be suggestive for the UK. 2 UK quarterly CPI data is from the O¢ ce of National Statistics; Tobin's q data is from the Bank of England, in which the methodology for computing q is described in Price and Schleicher (2005). The DSGE model has three features which give rise to such a negative relation between q and in ‡ation, namely (i) a Lucas and Prescott (1971) physical capital adjustment cost with a rising marginal cost of investment, (ii) human capital investment that endogenizes the balanced growth path equilibrium (BGP ) growth rate, and (iii) a cash-in-advance in ‡ation tax economy.…”

Investment, Tobin's Q, and Cash Flow Across Time and Frequencies

“…On the empirical side, using the present value approach to Q, Price and Schleicher () find that Q is positively related to investment and capital growth over medium and long horizons. More recently, two proxies for Q have been proposed in the literature as better predictors of investment than the standard measure of Q based on equity prices (in terms of the size and significance of the regression coefficient and fit of the investment regression).…”

Testing the Q Theory of Investment in the Frequency Domain

“…2 Using a shorter span of data for the UK, Price and Schleicher (2005) find that Q has predictive power for investment. Moreover, Rapach and Wohar (2007) find that the Q investment model -when compared to other investment models like the neoclassical model (Jorgenson, 1963) or the stock price model (Barro, 1990) -produces the most accurate one-quarter-ahead forecast.…”