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Tobin’s Q ratio is a popular 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 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 share capital of the company will coincide with the replacement cost and ratio will tend to approach 1. However, in the interim, this ratio can be higher or lower than this. 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 whereas replacement cost of the company is the cost which a new entrepreneur will have to incur to create the identical/similar company.
Interpreting Tobin’s Q ratio
- If Tobin’s Q ratio is significantly less than 1; it would mean that 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 larger than the replacement cost of the firm. In such a case it would entice market participants to set up similar outfits/companies in order to earn higher than the replacement value causing an increase in competitions. 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.
Q ratio though cannot be used as a daily indicator to buy or sell stocks but can be used to locate potential takeover targets in cases where Q ratio is less than 1.
In cases, where 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 q ratio seems very helpful; its correct estimation is not always easy as it faces a few limitations; Lets us have a look at some of the limitations of Q ratio.
Disadvantages of Tobin’s Q ratio
- Though the market value of the firm is easy to ascertain, the exact replacement cost for all assets may not be available as a secondary market for used equipment’s may not be always 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, it cannot be used to base investment decisions with regards to purchase/sale of equity shares.