Tobin's q
Encyclopedia
Tobin's q was developed by James Tobin
(Tobin 1969) as the ratio between the market value and replacement value of the same physical asset:
of the book equity:
The following graph is an example of Tobin's q for all U.S. corporations. The line shows the ratio of the US stock market value to US net assets at replacement cost since 1900.
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 fixed investment decisions on movements in the stock price; rather they examine future interest rates and the present value
of expected profits.
Tobin's q is said to be influenced by market hype and intangible assets so that we see swings in q around the value of 1.
, conversely it will be higher than Q. 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.
, Changyong Rhee and Lawrence Summers
found with data of the US economy from the 1920s to the 1990s that "fundamentals" predict investment much better than 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)
and Shimshon Bichler
, in their book Capital as Power, argue that Tobin's q has not operated according to the dictates of neoclassical theory. Instead of moving in the same direction, as is required by neoclassical theory
(since there should be symmetry between capitalization and real assets), the market value of corporate equities and bonds moves in the opposite direction to the current cost of corporate fixed assets.
If all markets cleared Tobin's q should normally average around 1, with the market value of corporate equities and bonds moving lock and step with the current cost of corporate fixed assets. But, instead, Nitzan and Bichler explain, Tobin's q has fluctuated wildly with a historical mean of 1.24. Typically neoclassical theory pins the high mean to "intangible assets" such as knowledge, technology, and goodwill since a corporation's balance sheet normally only includes machines and other tangible assets. Neoclassical theory further argues that the fluctuations in Tobin's q are due to 'irrational' bubbles and crashes which can be accurately forecasted by the market value of corporate equities and bonds moving up faster that the cost of corporate fixed assets in a bubble, or dropping faster than the cost of corporate fixed assets in a crash. The data, however, does not support this theory; instead of the changes of capitalization amplifying 'real' assets, they move in exactly the opposite direction (p. 178-181). When corporate assets increase in price, corporate equities and bonds drop, and vice-versa as seen in the graph below titled "U.S. Capital Accumulation and Fixed Assets". This, the authors claim, creates a problem for neoclassical theory and makes the relationship in Tobin's q meaningless.
James Tobin
James Tobin was an American economist who, in his lifetime, served on the Council of Economic Advisors and the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He developed the ideas of Keynesian economics, and advocated government intervention to...
(Tobin 1969) as the ratio between the market value and replacement value of the same physical asset:
One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for the newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.
Single company
Although it is not the direct equivalent of Tobin's q, it has become common practice in the finance literature to calculate the ratio by comparing the market value of a company's stock with its equity book value. The ratio Tobin's q is calculated by dividing the market value of a company by the replacement valueReplacement value
The term replacement cost or replacement value refers to the amount that an entity would have to pay to replace an asset at the present time, according to its current worth....
of the book equity:
- Tobin's q =
Aggregate corporations
Another use for q is to determine the valuation of the whole market in ratio to the aggregate corporate assets. The formula for this is:The following graph is an example of Tobin's q for all U.S. corporations. The line shows the ratio of the US stock market value to US net assets at replacement cost since 1900.
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 fixed investment decisions on movements in the stock price; rather they examine future interest rates and the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of expected profits.
Other influences on q
Tobin's q measures two variables - the current price of capital assets as measured by accountants or statisticians and the market value of equity and bonds - but there are other elements that may affect the value of q, namely:- Market hype and speculation, reflecting, for example, analysts' views of the prospects for companies, or speculation such as bid rumors.
- The "intellectual capitalIntellectual capitalThe value of an enterprise is made of physical assets, various financial assets and, finally, intangible assets, i.e., intellectual capital . The term intellectual capital conventionally refers to the difference in value between tangible assets and market value. ....
" of corporations, that is, the unmeasured contribution of knowledge, goodwill, technology and other intangible assets that a company may have but aren't recorded by accountants. Some companies seek to develop ways to measure intangible assets such as intellectual capital. See balanced scorecardBalanced scorecardThe Balanced Scorecard is a strategic performance management tool - a semi-standard structured report, supported by proven design methods and automation tools, that can be used by managers to keep track of the execution of activities by the staff within their control and to monitor the...
.
Tobin's q is said to be influenced by market hype and intangible assets so that we see swings in q around the value of 1.
Tobin's marginal q
Tobin's marginal q ,is the ratio of the market value of an additional unit of capital to its replacement cost.P/B ratio
In the case of inflationary time, Q will be lower than P/B ratioP/B ratio
The price-to-book ratio, or P/B ratio, is a financial ratio used to compare a company's book value to its current market price. The calculation can be performed in two ways, but the result should be the same each way. In the first way, the company's market capitalization can be divided by the...
, conversely it will be higher than Q. 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
Olivier BlanchardOlivier Blanchard
Olivier Jean Blanchard is currently the chief economist at the International Monetary Fund, a post he has held since September 1, 2008. He is also the Class of 1941 Professor of Economics at MIT, though he is currently on leave. Blanchard is one of the most cited economists in the world, according...
, Changyong Rhee and Lawrence Summers
Lawrence Summers
Lawrence Henry Summers is an American economist. He served as the 71st United States Secretary of the Treasury from 1999 to 2001 under President Bill Clinton. He was Director of the White House United States National Economic Council for President Barack Obama until November 2010.Summers is the...
found with data of the US economy from the 1920s to the 1990s that "fundamentals" predict investment much better than 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
Doug Henwood
Doug Henwood is an American journalist who writes frequently about economic affairs. He publishes a newsletter, Left Business Observer, that analyzes economics and politics from a left-wing perspective, and is a contributing editor at The Nation.- Early years :Henwood was born in Teaneck, New...
, 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)
Divergence from reality
Jonathan NitzanJonathan Nitzan
Jonathan Nitzan is a Professor of Political Economy at York University, Toronto, Canada. He is the co-author of Capital As Power: A Study of Order and Creorder, published 2009. Their writings focus of the nature of capital in capitalism and provide an alternative view to that of Marxist and...
and Shimshon Bichler
Shimshon Bichler
Shimshon Bichler is an educator who teaches political economy at colleges and universities in Israel. Along with Jonathan Nitzan, Bichler has created an engaging power theory of capitalism and theory of differential accumulation in their analysis of the political economy of wars, Israel, and...
, in their book Capital as Power, argue that Tobin's q has not operated according to the dictates of neoclassical theory. Instead of moving in the same direction, as is required by neoclassical theory
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...
(since there should be symmetry between capitalization and real assets), the market value of corporate equities and bonds moves in the opposite direction to the current cost of corporate fixed assets.
If all markets cleared Tobin's q should normally average around 1, with the market value of corporate equities and bonds moving lock and step with the current cost of corporate fixed assets. But, instead, Nitzan and Bichler explain, Tobin's q has fluctuated wildly with a historical mean of 1.24. Typically neoclassical theory pins the high mean to "intangible assets" such as knowledge, technology, and goodwill since a corporation's balance sheet normally only includes machines and other tangible assets. Neoclassical theory further argues that the fluctuations in Tobin's q are due to 'irrational' bubbles and crashes which can be accurately forecasted by the market value of corporate equities and bonds moving up faster that the cost of corporate fixed assets in a bubble, or dropping faster than the cost of corporate fixed assets in a crash. The data, however, does not support this theory; instead of the changes of capitalization amplifying 'real' assets, they move in exactly the opposite direction (p. 178-181). When corporate assets increase in price, corporate equities and bonds drop, and vice-versa as seen in the graph below titled "U.S. Capital Accumulation and Fixed Assets". This, the authors claim, creates a problem for neoclassical theory and makes the relationship in Tobin's q meaningless.
External links
- John Mihaljevic's Equities and Tobin's Q Report
- 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