Investment decisions, price-earnings ratios and finance. Evidence from firm-level data.

Economic theory suggests that firm’s investment depend on future growth opportunities, measured for example by price-earnings ratios, but might be dampened by inefficient financial markets. This paper tests these hypotheses using an unbalanced panel of 9,000 listed firms from 41 developed and developing markets, from 1990 to 2006. The empirical results confirm that managers use the information contained in the price-earnings ratios to make investment decisions. Moreover, stock market development and the specialization of the financial system towards arm’s length instead of bank financing has a positive effect on firms ’ investment decisions. Taken together, these results suggest that firms with higher growth opportunities accumulate more capital and that the stock market has a key role in channelling funds toward investment projects