Tobin's q

Tobin's q^[1] is a ratio comparing the market value of a company's stock with the value of a company's equity book value. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of the book equity:

Tobin's q =

Another use for q is to determine the valuation of the market as a whole. The formula for this is:

Application

If the market value reflected solely the recorded assets of a company, Tobin's q would be 1.0.

If Tobin's q is greater than 1.0, then the market value is greater than the value of the company's recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. High Tobin's q values encourage companies to invest more in capital because they are "worth" more than the price they paid for them.

If a company's stock price (which is a measure of the company's capital market value) is $2 and the price of the capital in the current market is $1; the company can issue shares and with the revenue invest in capital. In this case q>1.

On the other hand, if Tobin's q is less than 1, the market value is less than the recorded value of the assets of the company. This suggests that the market may be undervaluing the company.

John Mihaljevic points out that "no straightforward balancing mechanism exists in the case of low Q ratios, i.e., when the market is valuing an asset below its replacement cost (Q<1). When Q is less than parity, the market seems to be saying that the deployed real assets will not earn a sufficient rate of return and that, therefore, the owners of such assets must accept a discount to the replacement value if they desire to sell their assets in the market. If the real assets can be sold off at replacement cost, for example via an asset liquidation, such an action would be beneficial to shareholders because it would drive the Q ratio back up toward parity (Q->1). In the case of the stock market as a whole, rather than a single firm, the conclusion that assets should be liquidated does not typically apply. A low Q ratio for the entire market does not mean that blanket redeployment of resources across the economy will create value. Instead, when market-wide Q is less than parity, investors are probably being overly pessimistic about future asset returns."

Lang and Stulz found out that diversified companies have a lower Q-ratio than focused firms because the market penalizes the value of the firm assets.

Tobin's discoveries show us that movements in stock prices will be reflected in changes in consumption and investment, although empirical evidence reveals that his discoveries are not as tight as one would have thought. This is largely because firms do not blindly base investment decisions on movements in the stock price rather they examine the present value of expected profits and future interest rates.

Variables

Tobin's q reflects a number of variables, and in particular:

• The recorded assets of the company.
• Market sentiment, reflecting, for example, analysts' views of the prospects for the company, or speculation such as bid rumors.
• The intellectual capital of the company.

Since Tobin's q reflects a number of variables it can only be an approximation of the value of intellectual capital. Many companies now seek to develop ways to measure intangible assets such as intellectual capital. See balanced scorecard.

Tobin's marginal q

Tobin's marginal q is the ratio of the change in the value of the firm to the added capital cost for an increment to the capital stock.

P/B ratio

In inflationary time, Q will be lower than P/B ratio, conversely it will be higher than Q.^[1] During periods of very high inflation, the book value would not reflect the cost of replacing a firm's assets, since the inflated prices of its assets would not be reflected on its balance sheet.

Criticism

Blanchard, Rhee and Summers ^[2] found with data of the US economy from the 1920s to the 1990s that "fundamentals", predict investment much better that Tobin's q. What these authors call fundamentals is however the rate of profit, which connects these empirical findings with older ideas of authors such as Wesley Mitchell, or even Karl Marx, that profits are the basic engine of the market economy. Doug Henwood, in his book Wall Street, argues that the q ratio fails to accurately predict investment, as Tobin claims. "The data for Tobin and Brainard’s 1977 paper covers 1960 to 1974, a period for which q seemed to explain investment pretty well," he writes. "But as the chart [see right] shows, things started going away even before the paper was published. While q and investment seemed to move together for the first half of the chart, they part ways almost at the middle; q collapsed during the bearish stock markets of the 1970s, yet investment rose." (p. 145)

See also

• P/E ratio
• Dividend yield
• List of finance topics

External links

• John Mihaljevic's Equities and Tobin's Q Report
• The Q Ratio Sends a Modestly Bearish Long-Term Signal (July 2009)
• Tobin's Q Moderately Bullish on U.S. Equities (as of March 2009)
• The Manual of Ideas Launches Tobin's Q Research Service Based on James Tobin's Q Indicator
• Robert Huebscher on "The Market Valuation Q-uestion"
• Andrew Smithers' Q-Ratio FAQ
• Q-Ratio Graphs and Data

References

Notes

• ^  Tobin's q is sometimes written as "Tobin's-q", "Tobin's Q" or simply Q. It is also called Tobin's Quotient, since the Q stands for Quotient.

Sources

• Tobin J. (1969) "A general equilibrium approach to monetary theory", Journal of Money Credit and Banking, Vol 1No 1 pp 15-29

• Smithers, Andrew; Wright, Stephen (2000). Valuing Wall Street: Protecting Wealth in Turbulent Markets. McGraw-Hill. ISBN 0-07-135461-1