Tobin’s Q ratio is a popular replacement value method of estimating a stock’s fair value and can be practically used by market participants to make informed decisions. It is also known as the Q ratio or general equilibrium theory or Q theory. It is so-called in honor of US Nobel laureate James Tobin who proposed this ratio. We shall look at the calculations and interpretation of the same.
In the long run, the market value of the company’s share capital will coincide with the replacement cost, and the ratio will tend to approach 1. However, this ratio can be higher or lower than this in the interim. Let us now understand how this ratio can be used.
Formula for Calculating Tobin’s Q Ratio
Tobin’s Q Ratio = Market Price of the Company / Replacement Cost
The market price of the company means a price of a company based on the market traded price. In contrast, the replacement cost of the company is the cost that a new entrepreneur will have to incur to create an identical/similar company.
Interpreting Tobin’s Q ratio
- If Tobin’s Q ratio is significantly less than 1, it would mean that the market value is lesser than the replacement cost, which would mean the company is trading undervalued. In such a case, it would be better for corporate raiders or competitors to buy the firm rather than set up a similar setup/new outfit. This would lead to higher interest by competitors in the said company, and demand for it will cause the market price to increase and approach closer to 1.
- If Tobin’s Q ratio is significantly higher than 1, it would mean that the firm is earning a rate of return more prominent than the replacement cost of the firm. In such a case, it would entice market participants to set up similar outfits/companies to earn higher than the replacement value causing an increase in competition. Increasing new entrants will cause competition to increase and thereby market share to fall and profits to reduce, and the q ratio to start reducing and approach 1.
However, the Q ratio cannot be used as a daily indicator to buy or sell stocks but can be used to locate potential takeover targets in cases where the Q ratio is less than 1.
In cases where the Q ratio is more than 1, one can expect more entrants in the sector. However, if the ratio doesn’t approach closer to 1, it can signify entry barriers in the sector. In the long run, competition and mergers will play a role, and the Q ratio will approach to 1, indicating all companies, in the long run, will trade at their replacement cost value.
Though the use of the q ratio seems very helpful; its correct estimation is not always easy as it faces a few limitations; Let us look at some of the limitations of the Q ratio.
Disadvantages of Tobin’s Q ratio
- Though the firm’s market value is easy to ascertain, the exact replacement cost for all assets may not be available as a secondary market for used equipment may not always be available for all assets.
- Valuation of investments made and amortized on advertisements, research and development, and such intangible assets are not easy to value.
- Q ratio, though, compared with market price, cannot be used to base investment decisions regarding the purchase/sale of equity shares.