Stock Prices and Business Investment

By Leitner, Yaron | Business Review (Federal Reserve Bank of Philadelphia), Winter 2007 | Go to article overview

Stock Prices and Business Investment


Leitner, Yaron, Business Review (Federal Reserve Bank of Philadelphia)


Empirical evidence points to a link between the stock market and the amount of money firms spend on investment. A firm tends to invest more after the price of its stock increases, and it tends to invest less after the price falls. Investment could be in capital (for example, buying machines or buying a new plant) or in research and development (for example, developing a new drug).

Recent research has tried to come up with theoretical explanations and test them empirically. One important issue is whether the stock market actually improves investment decisions. This might be the case, for example, if the firm's stock price tells the firm something about the profitability of its investments--which might be the case if market participants have useful information or knowledge that the firm does not have. Interestingly, recent research has also suggested that while informed participants make prices more informative and therefore improve the firm's investment decisions, informed participants might also attempt to manipulate a firm's investment policies.

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THE STOCK MARKET CAN GUIDE INVESTMENT DECISIONS

Stock Prices Reflect Investors' Information About the Firm. Investors hold stocks because they expect to obtain dividends and/or make capital gains. When investors expect future profits to be high, they pay more to hold the stock; when investors expect profits to be low, they pay less. Investors do not know what future profits will be, but they can collect pieces of information that may help them assess the firm's value. For example, investors can look at the firm's financial statements as well as the financial statements of other firms in the industry. They can collect information about the firm's technology, the demand for its products, and its competitive environment. They can also look at other macroeconomic indicators; for example, a strong GDP report might strengthen investors' beliefs that demand for the firm's products is going to be solid. Using these pieces of information, each investor can come up with his own assessment of the firm's value. The stock price reflects these assessments.

When new information arrives, prices adjust. For example, the stock price of a biotech firm will rise after it announces that it passed the initial tests for approval of a new drug, and the price is likely to fall if the firm gets involved in a lawsuit. Passing the initial tests means that the firm is likely to generate more profits, and there fore, investors are willing to pay more to hold the stock. In contrast, being involved in a lawsuit means that the firm is likely to generate less profits, and therefore, investors are willing to pay less.

Investors May Have Information the Firm Does Not Have. Some of the information that investors have may be publicly available (for example, the firm's financial statements). However, some investors may have information no one else has.

Consider the following example: A large hedge fund, Short-Term Management (STM), hires a group of analysts whose job is to help choose which stocks to buy. These analysts carefully study the demand for a firm's products (for example, who will use a new drug) as well as the firm's position relative to its competitors'. The firm can also hire its own analysts, but since the firm is not in the business of choosing stocks, the cost of having its own group of analysts may outweigh the benefits.

STM may have a better assessment than the firm (as well as other investors) of the future demand for the firm's products and the firm's position relative to its competitors'. This assessment is called private information. In other words, private information refers to the data that STM's analysts gather as well as to their analysis of these data. The private information STM has allows it to evaluate the firm better than anyone else. (1)

How could STM use its private information to make a profit? …

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