Q Ratio (Tobin's Q Ratio)

Loading the player...

What is the 'Q Ratio (Tobin's Q Ratio)'

The Tobin's Q ratio is a ratio devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets.

Q Ratio (Tobin's Q ratio)

BREAKING DOWN 'Q Ratio (Tobin's Q Ratio)'

For example, a low Q (between 0 and 1) means that the cost to replace a firm's assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm's stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued. This measure of stock valuation is the driving factor behind investment decisions in Tobin's model.

Q-Ratio Formula and Example

The formula for Tobin's Q ratio takes the total market value of the firm and divides it by the total asset value of the firm. For example, assume that a company has $35 million in assets. It also has 10 million shares outstanding that are trading for $4 a share. In this example, the Tobin's Q ratio would be:

Tobin's Q ratio = total market value of firm / total asset value of firm = $40,000,000 / $35,000,000 = 1.14

Since the replacement costs of total assets is difficult to estimate, another version of the formula is often used by analysts to estimate Tobin's Q ratio. It is:

Tobin's Q ratio = (Equity Market Value + Liabilities Market Value) / (Equity Book Value + Liabilities Book Value)

Often, the assumption is made the market value and the book value of a company's liabilities are equivalent. This reduces this version of the Tobin's Q ratio to:

Tobin's Q ratio = Equity Market Value / Equity Book Value

Uses

An undervalued company, one with a ratio of less than one, would be attractive to corporate raiders or potential purchasers, as they may want to purchase the firm instead of creating a similar company. This would likely result in increased interest in the company, which would increase its stock price, which would in turn increase its Tobin's Q ration.

As for overvalued companies, those with a ratio higher than one, they may see increased competition. A ratio higher than one indicates that a firm is earning a rate higher than its replacement cost, which would cause individuals or other companies to create similar types of businesses to capture some of the profits. This would lower the existing firm's market shares, reduce its market price and cause its Tobin's Q ratio to fall.

RELATED TERMS
  1. Tobin Tax

    A means of taxing spot currency conversions that was originally ...
  2. James Tobin

    An American economist who won the Nobel Memorial Prize in Economics ...
  3. Regulation Q

    A Federal Reserve Board regulation that prohibited banks from ...
  4. Book-To-Market Ratio

    A ratio used to find the value of a company by comparing the ...
  5. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  6. Cash Asset Ratio

    The current value of marketable securities and cash, divided ...
Related Articles
  1. Markets

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  2. Markets

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  3. Investing

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  4. Markets

    How to Invest Your Excess Cash in Undervalued Securities

    Learn how even small investors can shoot for substantial capital gains by starting to invest their excess cash in undervalued securities.
  5. Trading

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  6. Markets

    Market Value Versus Book Value

    Understanding the difference between book value and market value is a simple yet fundamentally critical component to analyze a company for investment.
  7. Markets

    Wal-Mart's 5 Key Financial Ratios (WMT)

    Identify the five key financial ratios that fundamental analysts use to evaluate Wal-Mart's financial position and determine if its stock is a good buy.
  8. Trading

    Understanding The P/B Ratio

    A price to book ratio can tell an investor how the book value of a company measures up to its stock price. Find out how this ratio is calculated and how it can inform your investment decisions.
  9. Investing

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  10. Markets

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
RELATED FAQS
  1. How do I use ratios to perform a financial analysis?

    Learn which ratios are used in fundamental analysis. Find out how analysts measure company performance and financial health ... Read Answer >>
  2. How can a company quickly increase its liquidity ratio?

    Discover what high and low values in the liquidity ratio mean and what steps companies can take to improve liquidity ratios ... Read Answer >>
  3. Why do shareholders need financial statements?

    Discover the importance of a company's financial statements for stock shareholders in evaluating their equity investment ... Read Answer >>
  4. What other investment metrics are best used in conjunction with net margin?

    Learn about a number of other equity valuation measures that can best be used in conjunction with looking at a company's ... Read Answer >>
  5. What role does ratio analysis play in valuing a company?

    Learn about the role of ratio analysis in determining company value, including some of the most common ratios used by modern ... Read Answer >>
  6. How do stock dividends affect the retained earnings account?

    Understand the difference between financial ratio analysis and accounting ratio analysis. Learn why ratio analysis is important ... Read Answer >>
Hot Definitions
  1. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  2. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  3. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  4. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  5. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
  6. Security

    A financial instrument that represents an ownership position in a publicly-traded corporation (stock), a creditor relationship ...
Trading Center