“Do price-earnings ratios explain investment decisions better than Tobin’s q? Evidence from German firm-level data”

This article tests the additional information content of price-earnings ratios, with respect to Tobin’s q, in explaining firms’ investment behaviour. While Tobin’s q describes the expected future earnings related to those projected by the book value, the price-earnings ratio compares future growth of earnings based on the projection of current earnings. In other words, a high price-earnings ratio might indicate that investors are willing to rely on future earnings growth, even though current earnings are low. By using an unbalanced panel of about 500 listed firms from Germany over the period 1987–2007, we find that including the price-earnings ratio in the investment equation does not change the explanatory power of Tobin’s q. Most notably, the price-earnings ratio exerts a positive and significant impact on investment. These results are robust to the inclusion of a measure of the firm’s internal funds and of fixed effects and also to the use of different estimators.