Noisy Share Prices and the Q Model of Investment

We consider to what extent the empirical failings of the Q model of investment can be attributed to the assumption that stock market valuations accurately measure the present value of future net distributions to shareholders. We characterise the implications of different types of measurement error in the conventional average Q ratio that can result from the failure of this assumption, and show that plausible forms of measurement error can result in failure to identify the model's structural parameters. To explore this empirically, we use securities analysts' consensus earnings forecasts to construct an alternative measure of average Q, not based on share prices. Using this measure, we find more reasonable estimates of the size of adjustment costs, no significant cash flow effects, and no evidence of non-linearities. Indeed we find that our measure of average Q is a sufficient statistic for investment, and there is no additional information relevant for investment in stock market valuations. These results suggest that there are highly persistent deviations between stock market values and firms' fundamental valuations, and that these deviations are themselves correlated with fundamentals. This is consistent with rational bubble or noise trader models of share prices.