How Does Firm Investment Relationship Influence Stock Market Prices?

Firm Investment

How Does Firm Investment Relationship Influence Stock Market Prices?

Recent economic turmoil has made many people ask “what is Firm Investment?”. This is mainly because the recent economic crisis has weakened the concept of Firm Investment all around the world. Thus many economic analysts use the term ‘Firm Investment’ to explain what they are talking about. However, this definition is very vague and leaves a lot of room for misunderstanding.

Most Public Firms in Any Country suffer from Firm Investment misvaluation or mispricing at some point. Most often, this happens because of misvaluation induced by government intervention. As the size of the economy increases, public firms need to expand their activities and take on more debt to finance these activities. In fact, debt is not only used to finance these activities but it can also be used to diversify the portfolio. Therefore, as the economy grows, firms indulge in different types of risk management and become overweight.

The hypothesis predicts that if the government continues with its current policy of encouraging financial risk taking, public firms will continue to incur misvaluations. In addition, the level of economic activity would not likely decline significantly due to the growth in the size of the economy. However, if the economy of a country declines sharply, then firm investments will decline along with it. This is why the thesis also predicts that the current misvaluation cycle will last until the economy recovers.

Asset Value Management and Its Impact on Firm Investments: Another hypothesis predicts that the level of firm investments will decrease if the quality of the assets owned by public firms deteriorate. The decline in assets may be caused by the following: loss of business, a decrease in market share, increase in debt and default on loan obligations. However, this decrease will not automatically result to decline in the firm value. On the contrary, there are numerous instances where investment quality has declined but the asset value has fallen because there is no corresponding increase in assets. The concept of value engineering therefore can also be used in determining asset value.

Asset Value Management and Its Effect on Stock Market Prices: Under the hypothesis that firm investment will decline, stock market prices will decline as well. However, this decline cannot occur unless the economy of a country declines. If the economy of a country continues to perform in a satisfactory manner, stock market prices will continue to increase. The relationship between investment grade bonds and stock prices is the most obvious example of this link. When a firm invests in a low quality bond, its overall asset value declines, but the bond’s price is not affected.

Asset Value Management – Implications of Asset Value on Firm Investment and Stock Market Prices: Finally, the relationship between firm investment and stock market prices is explained in the concept of asset value engineering. Basically, this concept is designed to help managers assess the value of their firm and use it as a basis for valuing other assets. In simple terms, value engineering analyzes how market prices of particular assets to react to changes in financial factors, such as the economy or interest rates, for a particular asset. Once a manager identifies the asset’s potential worth, he can sell assets that are undervalued or overvalued. Thus, this method helps managers achieve their investment objective by determining which assets should be sold and which should be retained.