Cross-Sectional Tobin's Q

Abstract

The neoclassical investment model matches cross-sectional asset prices both in first differences and in levels. With ten book-to-market deciles as the testing portfolios, the investment model largely matches the Tobin’s Q spread, while maintaining a good fit for the average return spread across the extreme deciles. The model’s fit results from three aspects of our econometric strategy: (i) We test the model at the portfolio level to alleviate the impact of measurement errors; (ii) we match the first moment to mitigate the impact of temporal misalignment between asset prices and investment; and (iii) we allow for nonlinear marginal costs of investment. The model also does a good job in matching asset price levels within each industry, allowing technological heterogeneity across industries. We suggest that any differences between the intrinsic value and the market value of equity tend to dissipate in the long run.

Keywords: Tobin's Q, investment, valuation, structural estimation

JEL Classification: D21, E22, G12