THE ROLES OF EXPECTED PROFITABILITY , TO BIN'S Q AND CASH FLOW IN ECONOMETRIC MODELS OF COMPANY INVESTMENT

THE ROLES OF EXPECTED PROFITABILITY,
TOBIN’S Q AND CASH FLOW IN ECONOMETRIC
MODELS OF COMPANY INVESTMENT
Steve Bond
Alexander Klemm
Rain Newton-Smith
Murtaza Syed
Gertjan Vlieghe
THE INSTITUTE FOR FISCAL STUDIES
WP04/12

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The roles of expected profitability, Tobin’s Q
and cash flow in econometric models of
company investment
Stephen Bond∗
Alexander Klemm†
Rain Newton-Smith‡
Murtaza Syed§
Gertjan Vlieghe¶
June 29, 2004
Abstract
Evidence that cash flow has a significant effect on company invest-
ment spending, after controlling for Tobin’s average Q, has often been
interpreted as suggesting the importance of financing constraints. Re-
cent 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.
We explore this hypothesis empirically using UK panel data on com-
panies 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 profitabil-
ity using analysts’ earnings forecasts, cash flow becomes insignificant.
∗Nuffield College, Oxford and Institute for Fiscal Studies.
E-mail: steve.bond@nuf.ox.ac.uk
†Institute for Fiscal Studies.
‡Bank of England.
§Institute for Fiscal Studies.
¶Bank of England and London School of Economics.
E-mail: jan.vlieghe@bankofengland.co.uk

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Both sales growth and cash-stock variables do provide additional infor-
mation, which could either be capturing expectations of profitability
at longer horizons, or reflect misspecification of the basic Q model.
Results for subsamples do not suggest financing constraints as a likely
explanation for these findings.
Acknowledgement:
We thank Nick Bloom and Jason Cummins for many helpful discus-
sions, and participants at the Bank of England seminars for helpful
comments, particularly Hasan Bakhshi, Charlie Bean, Brian Bell, Ian
Bond, Roy Cromb, Anil Kashyap, Jens Larsen and Steve Nickell. This
research was funded by the Bank of England, with additional support
from the ESRC Centre for the Microeconomic Analysis of Public Pol-
icy at the Institute for Fiscal Studies. The data on securities analysts’
earnings forecasts were provided by IBES International. This paper
represents the views and analysis of the authors and should not be
thought to represent those of the Institute for Fiscal Studies, the Bank
of England or Monetary Policy Committee members.

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Summary
Econometric models of company investment face the problem that cur-
rent investment decisions depend on expectations of future conditions, but
these expectations are generally not observed. This makes it difficult to know
whether significant coefficients on financial variables, such as cash flow, in
empirical investment equations indicate the importance of financing con-
straints, or whether these variables simply provide additional relevant in-
formation about current expectations of future profitability. In this paper
we construct explicit measures of expectations of future profitability for UK
firms to address this question.
The Q model of investment relates investment to the firm’s stock market
valuation, which is meant to reflect the present discounted value of expected
future profits. Under certain assumptions about the firm’s technology and
competitive environment, the ratio of the stock market value of the firm
to its replacement cost (Tobin’s Q) should be a sufficient statistic for in-
vestment. Significant coefficients on cash-flow variables after controlling for
Tobin’s Q can then not be attributed to additional information about cur-
rent expectations. However, if the above conditions are not satisfied, or if
stock market valuations are influenced by ‘bubbles’ or any factors other than
the present discounted value of expected future profits, then Tobin’s Q would
not capture all relevant information about the expected future profitability of
current investment. In this case additional explanatory variables, like current
or lagged sales or cash-flow terms, could proxy for the missing information
about expected future conditions.
This problem is particularly important in the literature that tests for an
impact of financing constraints or capital market imperfections on corporate
investment. Many empirical studies have added cash-flow variables to empir-

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ical models that relate investment rates to Tobin’s Q, and interpreted signif-
icant coefficients on these cash-flow terms as evidence of ‘excess sensitivity’
of investment to the availability of internal funds. Although these findings
are consistent with the presence of a cost premium for external sources of
investment finance, they may also be explained, in the absence of financing
constraints, by observed cash-flow or profits variables containing additional
relevant information about expected future profitability not captured by To-
bin’s Q.
Recent findings for US data suggest that much, if not all, of the signifi-
cance of cash-flow variables in conventional estimates of Tobin’s Q investment
equations can be attributed to the failure of Tobin’s Q to capture all relevant
information about the expected profitability of current investment. Previous
studies using UK company data have reported significant coefficients on cash-
flow variables, both in the context of models that relate investment to Tobin’s
Q, and in the context of reduced-form empirical models without explicitly
forward-looking controls for expected profitability. The aim of the present
study is to consider the robustness of these findings to alternative controls
for expected future profitability. We obtain data on earnings forecasts from
IBES International for around 700 publicly traded UK companies between
1987 and 2000. We match this information with stock market valuations and
company accounts data on investment, cash flow and other financial variables
obtained from Datastream International. Our main finding is that, whereas
lagged cash flow is highly significant conditional on a standard measure of
Tobin’s Q, the coefficient on this cash-flow variable becomes insignificantly
different from zero when we include our direct measures of expected future
profitability. This parallels the results found for US data by other researchers.
We also examine subsamples of firms, and find that the results are robust

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across subsamples of smaller firms and low-dividend firms.
Although cash-flow variables become insignificant when we control for
expected profitability in this way, we find positive coefficients on both sales
growth and cash-stock variables that remain statistically significant after
conditioning on our measures of expected profits. These additional variables
could be capturing expectations of profitability in the longer term that are
not captured by our explicit measure of expectations. These longer-term
expectations would be relevant for explaining investment rates under the
maintained structure of the Q model. Alternatively, our findings could re-
flect misspecifications of the basic Q model, such as market power, decreasing
returns to scale, or non-convex components of adjustment costs. In principle,
the significance of these additional variables could also be due to the presence
of financing constraints, although our results for subsamples do not suggest
that this is a likely explanation. The coefficients on the additional sales
growth and cash-stock terms appear to be broadly similar between subsam-
ples of firms that have been considered elsewhere to be more or less likely to
be subject to significant financing constraints. So the additional information
these variables provide appears more likely to be explained by more general
features of the investment behaviour of UK firms.

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1
Introduction
Econometric models of company investment face the problem that current
investment decisions depend on expectations of future conditions, and these
expectations are generally not observed. This makes it difficult to know
whether significant coefficients on financial variables such as cash flow in em-
pirical investment equations indicate the importance of financing constraints,
or whether these variables simply provide additional relevant information
about current expectations of future profitability. In this paper we construct
explicit measures of expectations of future profitability for UK firms to ad-
dress this question.
The well-known Q model of investment relates investment to the firm’s
stock market valuation, which is meant to reflect the present discounted value
of expected future profits.1 For the special case of perfectly competitive mar-
kets and constant returns to scale technology, Hayashi (1982) showed that
average Q - the ratio of the maximised value of the firm to the replacement
cost of its existing capital stock - would be a sufficient statistic for investment
rates. The usual empirical measure, which we call Tobin’s Q, further assumes
that the maximised value of the firm can be measured by its stock market val-
uation. Under these assumptions, the stock market valuation would capture
all relevant information about expected future profitability, and significant
coefficients on cash-flow variables after controlling for Tobin’s Q could not be
attributed to additional information about current expectations. However if
the Hayashi conditions are not satisfied, or if stock market valuations are in-
fluenced by ‘bubbles’ or any factors other than the present discounted value
of expected future profits; then Tobin’s Q would not capture all relevant
information about the expected future profitability of current investment.
1 See Brainard and Tobin (1968) and Hayashi (1982).
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In this case additional explanatory variables like current or lagged sales or
cash-flow terms could proxy for the missing information about expected fu-
ture conditions. Cooper and Ejarque (2001) provide a recent illustration
of this mechanism, using simulated data from a model in which firms have
market power and average Q is not a sufficient statistic for investment rates.
This problem is particularly important in the literature which tests for
an impact of financing constraints or capital market imperfections on cor-
porate investment. Following Fazzari, Hubbard and Petersen (1988), many
empirical studies have added cash-flow variables to empirical models that
relate investment rates to Tobin’s Q, and interpreted significant coefficients
on these cash-flow terms as evidence of ‘excess sensitivity’ of investment to
the availability of internal funds.2 While these findings are consistent with
the presence of a cost premium for external sources of investment finance,
they may also be explained in the absence of financing constraints by observed
cash flow or profits variables containing additional relevant information about
expected future profitability that is not captured by Tobin’s Q.3 Again fol-
lowing Fazzari, Hubbard and Petersen (1988), the literature has sought to
address this concern by focusing on differential cash flow effects for subsam-
ples of firms that are considered more or less likely to face a significant cost
premium for external finance. However there are several problems with this
‘sample splitting’ approach, particularly when - as is commonly the case -
the coefficients on additional financial variables are found to be significantly
different from zero for all subsamples considered. Kaplan and Zingales (1997)
have argued that firms facing a higher cost premium for external funds need
2 See Schiantarelli (1996), Hubbard (1998) and Bond and Van Reenen (2003) for surveys
of this literature.
3 The latter explanation for significant cash-flow effects is still more likely to be rele-
vant in the context of reduced-form investment models, with no explicitly forward-looking
controls for the influence of expected future profitability.
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not display greater sensitivity of investment to fluctuations in cash flow.4
More straightforwardly, we cannot be confident that the additional informa-
tion about expected future profitability not contained in Tobin’s Q would
be similar across subsamples of firms. For example, ‘bubbles’ in share prices
may be more pervasive for the kinds of smaller firms, zero-dividend firms, or
firms without commercial bond ratings where larger coefficients on cash-flow
variables have often been reported.5
Recent research using US company data has shown that significant coeffi-
cients on cash-flow variables may not be robust to alternative ways of dealing
with measurement error in Tobin’s Q or alternative controls for expected fu-
ture profitability. Erickson and Whited (2000) develop a Generalised Method
of Moments (GMM) estimator using higher order moment conditions that can
correct for the presence of persistent ‘bubbles’, provided these ‘bubbles’ are
themselves independent of the firm’s fundamental value or present discounted
value of expected future profits. They find that the coefficient on an addi-
tional cash-flow variable becomes insignificant when they use this approach
to correct for measurement error in Tobin’s Q. Bond and Cummins (2001)
note that the Q model of investment may not be identified using the usual
measure of Tobin’s Q if there are ‘bubbles’ in stock market valuations that
are both persistent and themselves correlated with new information about
the firm’s fundamental value. The basic idea is that this would introduce
a measurement error component into the error term of the empirical invest-
ment equation which is likely to be correlated with past values of the firm’s
fundamental value, and hence with past observations on all variables that
4 See also the discussion in Fazzari, Hubbard and Petersen (2000) and Kaplan and
Zingales (2000).
5 This problem and other difficulties with the ‘sample splitting’ tests were noted by
Alan Blinder and James Poterba in their Brookings Panel discussions of Fazzari, Hubbard
and Petersen (1988).
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influence this fundamental value. In this case there would be no valid instru-
mental variables available for the usual measure of Tobin’s Q constructed
using stock market valuations. Bond and Cummins (2001) consider using
a direct estimate of the present discounted value of expected future profits,
constructed using earnings forecasts for individual companies made by pro-
fessional securities analysts. They too find that additional cash-flow variables
become insignificant when this estimate is used in place of the firm’s stock
market valuation to construct an alternative measure of the average Q ratio.6
These findings suggest that much if not all of the significance of cash-
flow variables in conventional estimates of Tobin’s Q investment equations
can be attributed to the failure of Tobin’s Q to capture all relevant informa-
tion about the expected profitability of current investment. Previous studies
using UK company data have reported significant coefficients on cash-flow
variables, both in the context of models that relate investment to Tobin’s
Q,7 and in the context of reduced-form empirical models with no explicitly
forward-looking controls for expected profitability.8 The aim of the present
study is to consider the robustness of these findings to alternative controls
for expected future profitability. We follow the Bond and Cummins (2001)
method and apply it to UK data. We obtain data on earnings forecasts from
IBES International for a sample of around 700 publicly traded UK companies
between 1987 and 2000. We match this information with stock market valua-
tions and company accounts data on investment, cash flow and other financial
6 See also Cummins, Hassett and Oliner (1999), who show that cash flow becomes
insignificant in this case for all the sub-samples of firms that have commonly been used in
the empirical literature on investment and financing constraints.
7 See, for example, Devereux and Schiantarelli (1990) and Blundell, Bond, Devereux
and Schiantarelli (1992).
8 See, for example, Bond, Harhoff and Van Reenen (1999) and Bond, Elston, Mairesse
and Mulkay (2003). Nickell and Nicolitsas (1999) find a significant negative coefficient on
an interest coverage measure of ‘financial pressure’, which is inversely related to cash flow.
4

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