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Uncertainty and investment: an empirical investigation using data on analysts' profits forecasts

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  • Stephen R. Bond
  • Jason G. Cummins

Abstract

We investigate the empirical relationship between company investment and measures of uncertainty, controlling for the effect of expected future profitability on current investment decisions. We consider three measures of uncertainty derived from (1) the volatility in the firm's stock returns; (2) disagreement among securities analysts in their forecasts of the firm's future profits; and (3) the variance of forecast errors in analysts' forecasts of the firm's future profits. We consider two controls for expected profitability: (1) a standard measure of Brainard-Tobin's q constructed from the firm's stock market valuation; and (2) an alternative measure of the q ratio constructed from discounted forecasts of the firm's future profits. Our sample consists of publicly-traded U.S. companies that were tracked by two or more securities analysts for at least four consecutive years between 1982 and 1999. The results show that all three measures of uncertainty are positively correlated and appear to pick up underlying movements in uncertainty. When we consider these measures individually, we find a significantly negative long-run effect of higher uncertainty on capital accumulation, which is robust to the inclusion of either of our controls for expected profitability. When we consider our uncertainty measures jointly, we find that the level of disagreement among analysts provides the most informative indicator for identifying this long-run effect of uncertainty on capital accumulation. In addition, we find a significantly negative short-run interaction term between share price volatility and current sales growth, consistent with the idea that investment will respond less to a given demand shock at higher levels of uncertainty. These effects of uncertainty on investment are shown to be quantitatively as well as statistically significant.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2004-20.

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Date of creation: 2004
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Handle: RePEc:fip:fedgfe:2004-20

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Keywords: Investments ; Risk ; Uncertainty;

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References

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  1. N. Gregory Mankiw & Ricardo Reis & Justin Wolfers, 2003. "Disagreement about Inflation Expectations," Harvard Institute of Economic Research Working Papers 2011, Harvard - Institute of Economic Research.
  2. Steve Bond & Alexander Klemm & Rain Newton-Smith & Murtaza Syed & Gertjan Vlieghe, 2004. "The roles of expected profitability, Tobin's Q and cash flow in econometric models of company investment," IFS Working Papers W04/12, Institute for Fiscal Studies.
  3. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  4. Guiso, L. & Parigi, G., 1996. "Investment and Demand Uncertainty," Papers 289, Banca Italia - Servizio di Studi.
  5. Hartman, Richard, 1972. "The effects of price and cost uncertainty on investment," Journal of Economic Theory, Elsevier, vol. 5(2), pages 258-266, October.
  6. Andrew B. Abel & Janice B. Eberly, . "The Effects of Irreversibility and Uncertainty on Capital Accumulation," Rodney L. White Center for Financial Research Working Papers 21-95, Wharton School Rodney L. White Center for Financial Research.
  7. Jason G. Cummins & Kevin A. Hassett & Stephen D. Oliner, 1999. "Investment behavior, observable expectations, and internal funds," Finance and Economics Discussion Series 1999-27, Board of Governors of the Federal Reserve System (U.S.).
  8. Cabalero, R.J., 1997. "Aggregaete Investment," Working papers 97-20, Massachusetts Institute of Technology (MIT), Department of Economics.
  9. John V. Leahy & Toni M. Whited, 1995. "The Effect of Uncertainty on Investment: Some Stylized Facts," NBER Working Papers 4986, National Bureau of Economic Research, Inc.
  10. Terence Lim, 2001. "Rationality and Analysts' Forecast Bias," Journal of Finance, American Finance Association, vol. 56(1), pages 369-385, 02.
  11. Nicholas Bloom & Steve Bond & John Van Reenen, 2001. "The dynamics of investment under uncertainty," IFS Working Papers W01/05, Institute for Fiscal Studies.
  12. Summers, Lawrence H, 1986. " Does the Stock Market Rationally Reflect Fundamental Values?," Journal of Finance, American Finance Association, vol. 41(3), pages 591-601, July.
  13. Caballero, Ricardo J, 1991. "On the Sign of the Investment-Uncertainty Relationship," American Economic Review, American Economic Association, vol. 81(1), pages 279-88, March.
  14. Steve Bond & Jason Cummins, 2001. "Noisy share prices and the Q model of investment," IFS Working Papers W01/22, Institute for Fiscal Studies.
  15. Michael P. Keane & David E. Runkle, 1998. "Are Financial Analysts' Forecasts of Corporate Profits Rational?," Journal of Political Economy, University of Chicago Press, vol. 106(4), pages 768-805, August.
  16. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, vol. 73(1), pages 228-33, March.
  17. Kothari, S. P., 2001. "Capital markets research in accounting," Journal of Accounting and Economics, Elsevier, vol. 31(1-3), pages 105-231, September.
  18. Stephen R. Bond & Jason G. Cummins, 2000. "The Stock Market and Investment in the New Economy: Some Tangible Facts and Intangible Fictions," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(1), pages 61-124.
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Citations

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Cited by:
  1. Panousi, Vasia & Papanikolaou, Dimitris, 2009. "Investment, idiosyncratic risk, and ownership," MPRA Paper 24239, University Library of Munich, Germany.
  2. Bachmann, Rüdiger & Bayer, Christian, 2013. "‘Wait-and-See’ business cycles?," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 704-719.
  3. Wang, Yizhong & Chen, Carl R. & Huang, Ying Sophie, 2014. "Economic policy uncertainty and corporate investment: Evidence from China," Pacific-Basin Finance Journal, Elsevier, vol. 26(C), pages 227-243.
  4. Baum, Christopher F. & Caglayan, Mustafa & Talavera, Oleksandr, 2008. "Uncertainty determinants of firm investment," Economics Letters, Elsevier, vol. 98(3), pages 282-287, March.
  5. Xie, Feixue, 2009. "Managerial flexibility, uncertainty, and corporate investment: The real options effect," International Review of Economics & Finance, Elsevier, vol. 18(4), pages 643-655, October.
  6. Alessandro Fiaschi, 2009. "Managerial discretion and optimal financing policies with cash flow uncertainty," Working Papers 3, Doctoral School of Economics, Sapienza University of Rome.
  7. Christopher F. Baum & Mustafa Caglayan & Oleksandr Talavera, 2010. "On the sensitivity of firms' investment to cash flow and uncertainty," Oxford Economic Papers, Oxford University Press, vol. 62(2), pages 286-306, April.
  8. Christopher F. Baum & Mustafa Caglayan & Oleksandr Talavera, 2006. "Firm Investment and Financial Frictions," Discussion Papers of DIW Berlin 634, DIW Berlin, German Institute for Economic Research.

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