Investment-Based Asset Pricing: Linking Investment Decisions to Asset Values

Investment-based asset pricing provides a powerful framework for understanding why assets are priced the way they are. Unlike traditional consumption-based models, which focus on investor utility derived from consumption, investment-based models emphasize the role of firms’ investment decisions and their impact on future cash flows. This approach suggests that asset prices are driven by firms’ willingness to invest and the marginal productivity of capital.

The core idea is that the required rate of return on an asset should reflect the opportunity cost of capital for firms. In other words, investors demand a return that is at least as good as what firms could earn by investing in new projects. This link is established through the firms’ investment decisions. When expected returns on existing assets are high, firms have a greater incentive to invest, boosting economic activity and driving up the value of assets. Conversely, low expected returns discourage investment, leading to lower asset values.

One key concept in this framework is the “q-theory” of investment. Tobin’s q is defined as the ratio of a firm’s market value to the replacement cost of its assets. A high q indicates that the firm’s market value is greater than the cost of replacing its assets, signaling profitable investment opportunities. Firms respond by increasing investment, which eventually brings q back to its equilibrium level of one. This investment activity affects the aggregate supply of assets and therefore influences asset prices.

Several prominent investment-based asset pricing models have been developed. One example is the production-based asset pricing model (PBAPM), which directly links asset returns to aggregate investment growth. The PBAPM predicts that assets with high returns in recessions, when investment is low, are riskier and require a higher risk premium. This is because these assets provide a hedge against periods of low investment and economic downturn. Another variation considers costly reversibility of investment, implying that firms are more cautious with investment decisions, especially in uncertain environments.

The strength of investment-based asset pricing lies in its ability to explain several asset pricing puzzles that challenge traditional models. For instance, the value premium, the tendency for value stocks (stocks with high book-to-market ratios) to outperform growth stocks, can be explained by differences in investment opportunities and sensitivity to investment risk. Value firms often have fewer growth opportunities and are more vulnerable to economic downturns, leading to a higher required rate of return.

However, investment-based asset pricing also faces challenges. Data on aggregate investment and capital stock can be difficult to obtain and measure accurately. Furthermore, some models can be complex and require strong assumptions about firm behavior and market efficiency. Despite these limitations, investment-based asset pricing remains a valuable tool for understanding the fundamental drivers of asset prices and the crucial link between financial markets and the real economy.