Internal Information and Investment Sensitivities to Market Value and Cash Flow

Abstract

A growing literature asserts that the quality of external reporting affects investment responses to market value and cash flow—frequently used proxies for investment opportunities and internal funds. However, such associations are also shaped by the quality of internal information. We predict that investment is more sensitive to internal profit signals and less sensitive to external market value signals when managers have higher quality internal information. In line with recent theoretical and empirical research, we proxy for internal information quality using observable information properties. We find that the sensitivity of investment to profitability is increasing, while the sensitivity of investment to market-to-book is decreasing in internal information quality. This evidence is consistent with internal information-based predictions and inconsistent with external reporting-based explanations. Our results offer new and unique insights robust to several alternative explanations and hold up using recently developed techniques to correct for measurement error in market valuations.