What Drives Marginal Q and Investment Fluctuations? Time-Series and Cross-Sectional Evidence

Abstract

We explore whether marginal Q and investment fluctuate due to revisions in expected marginal profits or discount rates, and by how much of each. We infer marginal Q from the marginal cost of investment, derive a present-value relation, and conduct a VAR-based variance decomposition for marginal Q. We find that discount rates (expected investment returns) drive the bulk of fluctuations in average Q and investment in the time series, but play no role in driving the cross-section of portfolios' average Q and investment. That is, marginal profits are the sole determinant of the cross-section of marginal Q and investment.

Keywords: Tobin's q; Present-value model; Investment return; Variance decomposition; VAR implied predictability; Aggregation bias; Marginal profit of capital; cross-section of q

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