The Marginal Profits-to-Q Ratio: Reassessing the Cash-Flow Channel

Abstract

We study a production-based present-value relation that implies that fluctuations in the marginal profit-to-marginal Q ratio (mq) are driven by variations in expected marginal profits growth (cash-flow channel), expected investment return changes (discount-rate channel), or both. We find that in contrast to the aggregate dividend-to-price ratio (dp), mq strongly predicts marginal profits growth at both short and long horizons, but not investment returns. mq also predicts the growth rates of aggregate earnings, industrial production, and non-farm payrolls. Overall, changing forecasts of cash-flow growth are an important feature of the economy, despite the failure of the dp to uncover such variation.

Keywords: Tobin's q; Marginal profits-to-q ratio; Investment return; Marginal profit of capital; Variance decomposition; VAR implied predictability; Aggregation bias; Long-horizon regressions; Dividend-to-price ratio; Structural estimation

JEL Classification: E22; E27; G10; G12; G17; G31