Measurement Error and the Relationship between Investment and<i>q</i>

TLDR

Empirical studies show that financially constrained firms’ investment is strongly driven by cash flow, yet q theory fails to capture this despite marginal q theoretically encompassing all relevant factors. The study investigates whether the failure of q theory to explain investment is caused by measurement error in marginal q. The authors employ measurement error–consistent generalized method of moments estimators to analyze investment‑q cash flow regressions. After correcting for measurement error, cash flow is irrelevant to investment, and q theory accurately explains investment decisions.

Abstract

Many recent empirical investment studies have found that the investment of financially constrained firms responds strongly to cash flow. Paralleling these findings is the disappointing performance of the q theory of investment: even though marginal q should summarize the effects of all factors relevant to the investment decision, cash flow still matters. We examine whether this failure is due to error in measuring marginal q. Using measurement error–consistent generalized method of moments estimators, we find that most of the stylized facts produced by investment‐q cash flow regressions are artifacts of measurement error. Cash flow does not matter, even for financially constrained firms, and despite its simple structure, q theory has good explanatory power once purged of measurement error.