Should managers, when making investment decisions, follow the signals
given by the stock market even if those do not coincide with their own
assessments of fundamental value? This paper reviews the theoretical arguments
and examines the empirical evidence, constructing and using a new US time
series of data on the q ratio from 1900 to 1988. We decompose q - - the ratio
of the market value of corporate capital to its replacement cost - - into the
product of two terms, reflecting "fundamentals" and "valuation", the ratio of
market value to fundamentals. We then examine the relation of investment to
each of the two, using a number of alternative proxies for fundamentals. We
interpret our results as pointing, strongly but not overwhelmingly, to a larger
role of "fundamentals" than of "valuation" in investment decisions.
*Published:
Quarterly Journal of Economics, Vol. 108, no. 1 (February 1993): 115-136.
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