This WealthHow article talks about the Tobin’s Q ratio, which is the measure of the economic viability of a firm, and tells you how to calculate it.
Who formulated it?
The Tobin’s Q ratio was formulated by James Tobin, who was a Nobel laureate and a professor of economics at the Yale University.
The Tobin’s Q ratio is a measure of the market value or the total value of the stocks of a company, in relation to the total value of the assets of the company. The value of the Q ratio is termed positive or negative, depending on whether its value is greater than or less than 1.
A positive Q ratio indicates that the market value of the company is higher than the cost to rebuild it. In other words, a company that earns substantial profits has a positive Q ratio, as the keen interest of potential investors in the stocks of the company causes the price of its shares to increase, thus increasing its market value.
How to Calculate the Tobin’s Q Ratio
The Q ratio is the ratio of the total market value of a firm to the total value of its assets. It is given by the following formula.
Q = Total Market Value of the Firm /Total Value of its Assets
From this ratio, we can make the following conclusions:
- If the value of Q is equal to 1, the market value of the firm is solely based on its assets.
- If the value of Q is less than 1, the market value is less than the value of assets.
- If the value of Q is greater than 1, market value is higher than the total value of the assets.
Now let us consider an example. Say, a company A has USD 5 million shares outstanding, each of which costs $10. The assets of the company are valued at USD 90 million.
The total market value of the company A is given by the product of the total number of shares outstanding and the individual value of each share
∴ The total market value = USD (5,000,000 x 10) = USD 50,000,000 i.e. USD 50 million.
Now, calculating the Tobin’s Q ratio for the company A, we get:
Q = USD 50,000,000 /USD 90,000,000 = 0.5
Based on the conclusions given above, we can say that in case of company A, which has a Q ratio less than 1, the market value is less than the value of its assets. It may also indicate that the company is not earning substantial profits.
The formula can be slightly altered to calculate the ratio of the value of the entire stock market to the aggregate corporate assets, and this is given below.
Q = Value of the Stock Market/ Net Worth of Corporate Assets
If the value of the Q ratio for the entire stock market is less than 1, it indicates a bearish tendency and the investors being pessimistic.
What the Critics Say
James Tobin hypothesized that the market value of a firm should ideally be equal to the cost or replacement value of its assets. Hence, if a firm has a Q ratio greater than 1, it is considered as overvalued according to the hypothesis. The concept of the Q ratio and its effect in predicting investment patterns, has garnered much criticism. One of the more famous critics was Doug Henwood, who is also the author of the book Wall Street. He was of the opinion that the concept of the Q ratio was not universal, and that it was only meant for the economic or market conditions of the period between 1960 and 1974.
For the value of the Q ratio to be accurate, you should ensure that the value of both parameters are as exact as possible. In the year 1981, economists Eric B. Lindenberg and Stephen A. Ross observed that firms with a higher value of Q, tend to produce unique products, while those with lower values of the Q ratio, were the ones that were a part of a highly competitive market.