The roles of expected profitability, Tobin's Q and cash flow in econometric models of company investment

Stephen Bond

"Evidence that cash flow has a significant effect on company investment spending, after controlling for Tobin's average Q, has often been interpreted as suggesting the importance of financing constraints. Recent work on measurement error in the Q model casts doubt on this interpretation. It is possible that the Q model may not be identified if there are 'bubbles' in stock market valuations that are both persistent over time and that are correlated with fundamental values. Cash flow may then provide additional information about expected profitability that is not captured by a poorly measured Tobin's average Q variable. This hypothesis is explored empirically using UK panel data on companies for which analysts' earnings forecasts are available from the IBES database. The results point to a severe measurement error in average Q. The paper finds that, controlling for expected...