April 10, 2021
Do stock prices affect corporate investment?
A central function of financial markets is to produce information about companies. A high stock price reflects that a company has good products and is using the right set of technologies. But stock prices are more than that. Because stocks are claims on companies' future dividends, stock prices also – and in fact, mostly – contain information about the future of companies. A high stock price reflects that the company is forecast to have good products in the future and is developing technologies that will be valuable in the future.
The forward-looking nature of stock prices explains, for example, why the valuation of carbon-intensive companies is declining, sending them a signal that they should stop investing in carbon-intensive projects.
Do companies actually take into account the information embedded in stock prices?
A recent study by an HEC team of researchers evaluates whether corporate investment reacts to stock prices. Their analysis uses data on corporate investment and stock prices of all US listed firms over the last two decades.
The first pattern the researchers uncover in the data is that companies increase investment when their stock price increases. One must be cautious when interpreting this pattern because correlation is not causation. It could be that firms that invest more have high stock prices because they have good investment opportunities, rather than these firms investing because they have high stock prices. In other words, it is a priori unclear whether causality runs from stock prices to corporate investment or from corporate investment to stock prices.
To establish causality, the researchers identify situations in which the stock price is high for reasons unrelated to the investment opportunities of the company. Such situations arise when a mutual fund faces redemptions from its investors, forcing the fund to sell a fraction of its portfolio to repay investors redeeming their shares. This pushes down the stock price of companies in the fund's portfolio for reasons unrelated to the investment opportunities of these companies. These "non-fundamental" shock to stock price provide the researchers with a unique opportunity to test whether corporate investment reacts to stock prices above and beyond reacting to investment opportunities.
Strikingly, they find that companies cut investment when the stock price drops for non-fundamental reasons. This finding has two implications. First, stock prices are not a side show. They have an impact on real investment decisions. Second, the degree of stock price informativeness has real consequences. When stock prices move for non-fundamental reasons, corporate investment decisions are distorted by stock market noise.
The researchers found another fascinating pattern in the data. The stock price of a company also impacts investment decisions by other companies in the same industry. The reason is that information about a given firm is relevant for companies that operate in the same space or rely on the same technologies.
The study focuses on investment by listed firms. A conjecture is that the logic extends to investment decisions of private firms, startups, and probably venture capital. The valuation of public companies contains information about the technologies they invest in, which is relevant for entrepreneurs and their investors who have to make innovation and strategic decisions.
 The study discussed in this article is by Dessaint, Frésard, Foucault and Matray, 2019, Noisy Stock Prices and Corporate Investment, Review of Financial Studies [pdf]
This study is part of a recent line of research that explores the connection between financial markets and the real economy and emphasizes the notion that financial markets are not only a zero-sum game (although they're also that) as the information embedded in the price of financial assets is a useful input for decision-making in the broader economy.