Economic issues include:

• Tobin's q theory

• The Efficient Markets Hypothesis

• Psychology, behavioural economics and neuroeconomics

Econometric issues include:

• Identifying correct functional form

• Model misspecification errors

• Ramsey's RESET tests for model misspecfication

Data issues include:

• Measuring stock market value

• Measurement error

The issue

In this chapter, stock market valuation methods of investment appraisal are introduced and applied to US fixed asset investment data. In a simple world, business entrepreneurs use two factors of production when they are producing their goods and services: capital and labour. Fixed asset investment is about the first. As businesses invest in new plant, machinery and equipment they generate a flow of new capital goods into the stock of capital. This capital stock (when combined with labour inputs) will determine the future productive capacity both of the firm at a microeconomic level and of the macro-economy as a whole.

Some early investment theories focused on investment as the outcome of firms balancing the marginal benefits and marginal costs of buying units of new capital but these theories could not easily explain the timing of investment decisions. Also, they neglected the role of expectations and uncertainty. This was an important omission because investment is all about planning for the future: expectations and uncertainty have crucial impacts on entrepreneurial decision-making. The problem is that expectations are not observable and so one solution is to use stock market data on market capitalisations to capture investors' expectations about the future, as explained below.