Fundamental Stock Price and Investment

This paper examines the issue of whether a firm's investment decisions respond more to market fundamentals than to bubbles. Using firm level data from COMPUSTAT, we design various proxies for market fundamentals based on (i) the dividend approach, (ii) the dividend smoothing approach, and (iii) the earnings approach. From the aggregated micro data, we find that business investment responds more to market fundamentals than to bubbles. On the other hand, results from the panel regressions are inconclusive since most of the explanatory power of the investment regression is derived from the individual firm specific effect.