There is a close relation between the stock market and investment. Fluctuations in the stock market can affect investment of firms. The relationship between stock prices and firms’ investment in physical capital is captured by the “q theory of investment”, developed by James Tobin. Suppose a firm has 10 machines and 10 shares outstanding—one share per machine. Suppose the price per share is Rs 100 and the purchase price of a machine is only Rs 50.

It is quite obvious that the firm should invest—buy a new machine—and finance it by issuing a share. Each machine costs the firm Rs 50 to purchase, but stock market participants are willing to pay Rs 100 for a share corresponding to this machine when it is installed in the firm.

In effect, the stock price tells firms how much the stock market values each unit of capital already in place. So the investing firm has a simple exercise to perform. It has to compare the purchase price of an additional unit of capital to the price the stock market is willing to pay for it.

If the stock value exceeds the purchase price, the firm should buy the machine; otherwise, it should not. On the basis of this simple exercise Tobin constructed a variable corresponding to the value of a unit of capital in place relative to its purchase price, and examined how closely it moved with investment.

He used the symbol ‘q’ to denote the variable, called Tobin’s q. Its construction goes as:

1. We have to take the total value of Indian corporations, as assessed by financial markets, that is, compute the sum of their stock market value (the price of a share times the number of shares). We also compute the total value of their bonds (debentures) outstanding (firms finance themselves not only through stocks but also through bonds and debentures). So we have to add together the value of stocks and bonds.

2. Then we have to divide this value by the value of the capital stock of Indian corporations at replacement cost (the price firms would have to pay to replace their machines, their plants, and so on).

The ratio gives us, in effect, the value of a unit of capital in place relative to its current purchase price. This ratio is Tobin’s q.

Tobin argued that the rate of investment in any particular type of capital can be predicted by looking at the ratio of the capital’s market value to its replacement cost. Intuitively, the higher the q, the higher the value of capital relative to its current purchase price, and the higher will be investment.

When Tobin’s q is greater than 1, it is profitable to acquire additional capital because the value of capital exceeds the cost of acquiring it. Similarly, when Tobin’s q is smaller than 1, the value of capital is less than the cost of acquiring it. So it is not profitable to invest in additional capital.

Link between the Stock Market and Investment:

There is a close link between the stock market and investment in the economy. The reason is simple. Since much of the value of firms comes from the capital they own, we can use the stock market value as a measure of the market value of a firm’s capital stock. Let V be the stock market value of a firm, K be the amount of capital the firm owns, and pk be the price of new capital goods, then, for an individual firm

where pkK is the replacement cost of the firm’s capital stock. If the replacement cost is not changing much, a boom in the stock market (an increase in V) will cause Tobin’s q to rise for most firms leading to increased rates of investment.

Essentially, when the stock market is high, firms find it profitable to expand. So they invest more in physical assets. Thus, Tobin’s q establishes a relation between financial capital (share and stock) and real capital (plant, equipment and machinery). A boom in the stock exchange makes it easy for firms to raise more external capital for financing real investment.

Determinants of q:

Three main factors affecting the desired stock of capital are the expected future marginal product of capital, the real interest rate and the purchase price of new capital.

Each of these factors also affects Tobin’s q:

1. An increase in the expected marginal product of capital tends to increase the future earnings of the firm, which raises the stock market value of the firm and thus increases q.

2. A reduction in the real rate of interest also tends to raise stock prices (and hence q), as financial investors substitute away from low-yielding bonds and bank deposits and buy stocks instead.

3. A fall in the purchase price of capital reduces the denominator of the q ratio and, thus, increases q.

Since all three types of changes increase Tobin’s q, they also increase the desired capital stock and investment, as predicted by the modern theory of investment.

Limitations:

Empirical studies have revealed that investment in new capital goods tends to rise when the stock market rises and fall when the market falls. Data show the strongest relation between investment this year and Tobin’s q last year.

In other words, movements in investment this year are more closely associated with movements in the stock market last year rather than with movements in the stock market this year; a plausible explanation is that it takes time for firms to make investment decisions, build new factories, and set up new plants. However, the relationship is not always strong.

The problem is partly attributable to the fact that, in practice, stock prices reflect many assets besides capital such as the patents a firm holds or the reputation of a firm’s products. Thus, changes in stock prices are imperfect measures of the changes in the market value of capital.