EITM: Firm-Specific Capital and the Secular Rise of Tobin's Q

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The project studies the upward trend in stock market valuations of firms over the last century. It assembles and analyzes a massive data set on firm balance sheets and stock market valuations. These data are used to test and develop a theory that rising stock market valuations are due to rising firm-specificity of assets. A rising specificity of assets makes it easier to transfer more rents to the owners of the firm. The rise of management in general and, more specifically, the growing importance of the information processing role of managers played a key role in this result. Market to book value of firms (Tobin's Q) has risen a lot since 1980. The usual explanation is an increase in the importance of intangible investments and organization capital. These investments are not on the books of firms, and Q's are thereby biased upwards. There are two reasons why intangibles are not likely to be the whole story. First, the rise in Q's has happened within sectors and, in particular, in manufacturing sectors. And, second, the rise is not a new-economy phenomenon but is a century-long trend, and this includes the traditional sectors. This project hypothesizes that some of the rise in Q's is due to a steadily rising firm-specificity of assets. Evidence for rising specificity is a dramatic reduction in labor turnover over the century, and a reduction in entries and exits of firms that result in the dispersal of physical and human assets. Like the intangibles hypothesis, this theory also implies that as a percentage of the tangible capital stock earnings ought to have risen - and they have by more than 60 percent since the late 1920's. But this project's model of the division of the rents - based on auction theory - leads to a different test. The model will be one in which a firm's profits depend on how efficiently its managers can procure the human and physical capital that the firm specifically needs. The specificity of the assets to the firm will mean that there will be a rent that is somehow split between the firm and the factors in question. The test relies on the cross-section variability of Q 's and the earnings to capital. These measure the dispersion in firms' abilities to procure high quality assets at a low price. In this model a rise in the dispersion of Q 's signals a rise in the specificity of assets. The investigators estimate the model using macroeconomic time series on profit rates, the skill premium, capital and labor inputs, and GDP from 1929 to 2001 and find that the data are consistent with increasing firm specificity of capital. This project will improve the model and refine the data. Broader impacts: Wild swings in the market can have a strong impact on the real economy, and so it is important to know if the market is overvalued. This analysis shows that one part of the rise in the market is warranted by fundamentals - in this case a rise in the shareholder's portion of the firm's rents.