The Great Reversal: How America Gave Up on Free Markets

by Thomas Philippon

Making an investment decision therefore requires a complicated discounting of uncertain future cash flows and a comparison with the current cost of buying new capital. How can these decisions be made for the whole economy, with thousands of businesses, hundreds of billions of dollars of cash flows and investment costs? How can predictions be made not only one year ahead, but two, five, ten, or twenty? It sounds like a daunting task, and it is. But if you think about it the right way and make some assumptions, you can see that accountants, together with stocks and bonds traders, have done it for us. This was the brilliant insight of Nobel Prize winner James Tobin. The measure that “looks at it the right way” is called Tobin’s q and is explained in Box 4.1. Tobin’s insight is that the market value of the firm encodes all we want to know about the firm, at least as far as classical investment decisions are concerned. If accountants do their job properly, then we can measure the replacement cost of the firm’s fixed assets. If investors do their job properly, then we can measure the market value that the firm creates from these fixed assets. The difference between the market value and the replacement cost is the NPV of the firm. Tobin’s q is the ratio of the market value to the replacement cost. If q is more than one, the firm should scale up because each additional $1 of capital expenditure is worth q dollars. Tobin’s q contains a lot of information. In particular, Tobin’s q c...