Investment, Valuation, and Growth Options

A firm's value depends on both its existing capital and its available technologies, even if they are not yet installed. In contrast, the firm's current investment depends only on the currently installed technology. Thus, the value of the firm, and hence Tobin's Q, are "too forward-looking" relative to the investment decision. Cash flow, on the other hand, reflects only current technology and demand. The excessively forward-looking information in Tobin's Q, while extraneous to high frequency investment decisions, does predict future adoptions of the frontier technology. In this way, it is a better predictor of long-run investment than of short-run investment. Short-run investment is better predicted by the firm's cash flow.