Q for the Long Run

Traditional Q theory relates a firm’s investment to its value of Q at all fre-quencies; weekly or even daily fluctuations in Q should be just as informative for investment decisions as quarterly or annual data. We develop a model in which investment is more responsive to Q at long horizons than at short horizons; in-stantaneous investment is responsive to contemporaneous cash flow. These effects arise because a firm’s value depends on both its existing capital and its available technologies, even if they are not yet installed. In contrast, the firm’s current investment depends only on the currently installed technology. Thus, the value of the firm, and hence Tobin’s Q, are “too forward-looking ” relative to the investment decision. Cash flow, on the other hand, reflects only current technology and demand. The excessively forward-looking information in To-bin’s Q, while extraneous to high-frequency investment decisions, does predict future adoptions of the frontier technology. In this way, it is a better predictor of long-run investment than of short-run investment. Short-run investment is better predicted by the firm’s cash flow. We thank seminar participants at Columbia University, the Federal Reserve Bank of New York, and the Society for Economic Dynamics for helpful comments, as well as those at the University of Lausanne, the University of Michigan, and University College, London for their input on an earlier version of this paper.