Q Ratio (Tobin's Q) - Explained
What is a Q Ratio?
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Table of ContentsWhat is a Q Ratio (Tobin's Q)?How Does Tobin's Q Ratio Work?What Is Replacement Value?Example of How to Use Q-RatioOther Uses of Tobin's Q RatioLimitations of Tobin's Q
What is a Q Ratio (Tobin's Q)?
The Tobins Q ratio is the ratio between the market value of physical assets and their replacement value or cost. The Tobins Q ratio was first proposed by Nicholas Kaldor, an economist in 1966. This ratio was further popularized by James Tobin of Yale University, who the ratio was eventually named after. According to Tobins Q ratio, the value of a company is the total asset value of the company divided by its market value. Tobins Q ratio also posits that the market value of companies should equal their replacement costs.The Tobins Q ratio measures the ratio between the market value of a physical asset and its replacement cost. The formula for calculating Tobins Q ratio is:
Tobins Q = Total Asset Value of Firm / Total Market Value of Firm,
Tobins Q = Equity Book Value / Equity Market Value
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How Does Tobin's Q Ratio Work?
The Tobins Q ratio expresses the relationship between the intrinsic value of a physical asset and its market valuation. With this ratio, one can easily know whether a particular business, industry or market is overvalued or undervalued. Also, it expresses the variance between the replacement cost of a company and the market value. For instance, if the replacement costs of a companys assets are lower in value than the firms stock, the stock is said to be overvalued. When the Tobins Q ratio of a firm or market is more than one, the market is overvalued and when it is less than one, it is undervalued. Here are some important things to know about Tobins Q ratio;
- The Q Ratio is otherwise called Tobins Q ratio, it maintains that the market value of a company or business equals its replacement cost.
- The Q Ratio was first used by Nicholas Kaldor in his article published 1966 and later popularized by the Novel Laureate, James Tobin, who the ratio was named after,
- This ratio estimates whether a company or market is overvalued or undervalued, by checking the difference between their market value and replacement cost or value.
What Is Replacement Value?
Replacement value is also known as replacement cost, this is the amount of money it costs a company to replace an existing asset given the current market price. The past time or time of purchase of the asset does not count in the replacement cost rather, the present time is considered. For instance, if you purchased an asset in 2018 for $400 and as of 2019, the cost of replacing it is $150, the replacement value is $150. The current worth of an asset is an important factor when measuring the replacement cost. Replacement value is crucial in the calculation of the Q ratio of a business, this value is not restricted to certain businesses or industries.
Example of How to Use Q-Ratio
The formula for calculating the Q ratio is;
TobinsQ = Total Asset Value of Firm / Total Market Value of Firm
With the above formula, the Tobins Q ratio divides the total market value of a firm by the total value of assets owned by the firm. If the ratio is more than 1.0, it means the company or market is overvalued given that the firms market value is more than its replacement value. If the ratio is less than 1.0 on the other hand, it means the market in undervalued, because the market value is below the replacement value.
Other Uses of Tobin's Q Ratio
Aside from being used to measure the relationship between the market value and intrinsic value of an asset, the Q Ratio or Tobins Q ratio has the following uses;
- It indicates how attractive a company or business would be to investors and potential buyers.
- It indicates whether a company or market is overvalued or undervalued.
- The Q Ratio measures the relative values of aggregate market indexes or the market wholes.
Limitations of Tobin's Q
Since its introduction in 1966, the Tobins Q ratio has continued to be used to measure the market value of a company in relation to its replacement value. The Q Ration has certain limitations, the major drawbacks of Toibins Q as pointed out by critics are;
- The Tobins Q ratio fails to accurately measure or predict the outcomes of investments for given periods.
- The ratio sometimes also fail to predict a market o company as being overvalued or undervalued.
Given these shortcomings of the Q Ratio, some ratios or data are proven to given better results and more precise predictions than the Tobins Q ratio.