What is Q Ratio (Tobin's Q)
The Tobin's Q ratio equals the market value of a company divided by its assets' replacement cost. Thus, equilibrium is market value equals replacement cost. The Tobin's Q ratio is a ratio popularized 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.
While Tobin is often attributed as its creator, this ratio was first proposed in an academic publication by economist Nicholas Kaldor in 1966. In earlier texts, the ratio is sometimes referred to as Kaldor's v.
The Formula for Tobin's Q is
Calculating Tobin's Q
Since the replacement cost 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 = (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 = Equity Market Value / Equity Book Value
What Tobin's Q Ratio Tells You
At its most basic level, Tobin’s Q Ratio expresses the relationship between market valuation and intrinsic value. In other words, it is a means of estimating whether a given business or market is overvalued or undervalued. (For more, see: Value Investing.)
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 Q ratio. When applied to the market as a whole, we can gauge whether an entire is relatively overbought or undervalued - we can represent this relationship as follows:
Q Ratio (Market) = Market Capitalization of all Companies / Replacement Value of all Companies
For either a firm or a market, a ratio greater than one would theoretically indicate that the market or company is overvalued. A ratio less than one would imply that it is undervalued.
Underlying these simple equations is an equally simple intuition regarding the relationship between price and value. In essence, Tobin’s Q Ratio asserts that a business (or a market) is worth what it costs to replace. The cost necessary to replace the business (or market) is its replacement value.
- The Q Ratio was popularized by Novel Laureate James Tobin and invented in 1966 by Nicholas Kaldor.
- The Q measures if either a firm or an aggregate market is relatively over- or under-valued
- It relies on the concepts of market value and replacement value.
What is “Replacement Value”?
Replacement value (or replacement cost) refers to the cost of replacing an existing asset based on its current market price. For example, the replacement value of a one-terabyte hard drive might be just $50 today, even if we paid $500 for the same storage space a few years ago.
In this scenario, ascertaining the replacement value would be easy because there is a robust market for hard drives from which to examine prices. To determine what a one-terabyte hard drive is worth, we would simply need to determine what it would cost to buy a one-terabyte hard drive (of comparable quality and specifications) from one of the many different suppliers on the market. In many cases, however, the replacement value of assets can prove much more elusive than this.
For instance, consider a business that owns complicated software tailor-made for its operations. Because of its highly specialized nature, there may not be any comparable alternatives available on the market. Unlike our previous example, we could not simply check to see how much similar software is selling for, because sufficiently similar software would not exist. It would therefore be difficult, if not impossible, to render an objective estimate of the software’s replacement value.
Similar circumstances present themselves in a variety of business contexts, from complex industrial machinery and obscure financial assets through to intangible assets such as goodwill. Due to the inherent difficulty of determining the replacement value of these and similar assets, many investors do not regard Tobin’s Q Ratio to be a reliable tool for valuing individual companies.
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 ratio is greater than 1.0, the market value exceeds the replacement value and so we could say the firm is overvalued and might be a sale.
Uses of Tobin's Q Ratio
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 ratio.
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.
It is also used to determine the relative value of aggregate indexes or market wholes. It might seem logical that fair market value would be a Q ratio of 1.0. But, that has not historically been the case. Looking at U.S. Financial Accounts data (Z.1), the average (arithmetic mean) Q Ratio is about 0.70. This number, however, fluctuates: The all-time Q Ratio high at the peak of the 2001 Tech Bubble was 1.61 — which suggests that the market price was 136% above the historic average of replacement cost at the time. The all-time lows occur in 1921, 1932 and 1982 were they stood around 0.30, which is approximately 55% below replacement cost.
Limitations of Tobin's Q
Tobin's Q is still used in practice, but others have since found, using data of the US economy from the 1920s to the 1990s, that so-called "fundamentals" predict investment results much better than the Q ratio. These include the rate of profit - either for a company or the average rate of profit for a nation's economy.
Others, like Doug Henwood in his book Wall Street, find that the Q ratio fails to accurately predict investment outcomes over important time period. The data for Tobin's original (1977) paper covered the years 1960 to 1974, a period for which Q seemed to explain investment pretty well. But looking at other time periods, the Q fails to predict over- or undervalued markets or firms. While Q and investment seemed to move together for the first half of the 1970s, the Q collapsed during the bearish stock markets of the late 1970s, even as investment in assets rose.