Q Ratio (Tobin's Q Ratio)

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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.