Capital Expenditures and Firm Performance: Evidence from a Cross-Sectional Analysis of Stock Returns

Abstract

It is well established that firms that undertake high levels of capital investment relative to their scale of operations, as measured by total assets, sales, or similar criteria, tend to have lower subsequent stock returns than firms with the opposite characteristic. Intuitively, this finding is consistent with the hypothesis that firms evaluate investment projects using hurdle rates that reflect expected stock returns, thereby inducing a negative cross-sectional correlation between realized stock returns and observed investment levels. We use a simple two-period model of firm investment to formalize this intuition, and show that the model predicts that the function that relates stock returns to investment is nonlinear, i.e., its slope varies with the level of investment. This prediction finds substantial support in the data. The evidence indicates that the slope of the investment function is negative at low investment levels, close to zero at intermediate investment levels, and negative at high investment levels. Our results, which are robust to the use of narrowly- and broadly-defined measures of capital investment, pose a challenge to the hypothesis that the negative correlation between investment and stock returns is attributable to some sort of overinvestment phenomenon.