Tobin’s Q Ratio Is A Great Metric For Value, Not So Great For Valuing Growth
Dec 10, 2008
Author: SCP Editor
December 10, 2008 – The “Q Ratio” is getting attention this morning, which is a system developed by 1969 Nobel Prize winning economist James Tobin. The Q Ratio is a way of comparing the value of stocks of a public company with the value of its book value. It can also be used to value the market as a whole. And according to CLSA Ltd. strategist Russell Napier, the S&P is still really expensive relative to the cost of replacing assets, and from an historical perspective, the Q Ratio indicates the S&P may decline by another 55% to 400 by 2014. Ugh.
What is Q Value?
Q=(market cap + liabilities book value/ equity book value + liabilities book value), in the case of individual companies, and
Q= (value of stock market/ corporate net worth) in the case of the broader markets.
If the Q value is greater than 1, the market (or stock) value is greater than the value of its recorded assets.
According to Napier, the Q ratio for U.S. stocks has dropped to 0.7 from a peak of 2.9 in 1999, where reaching 0.3 has been an historical indicator for the end of a bear market. Napier says the Q ratio has always ranged between 0.3 and 3 in the past 130 years (pace 1921, 1932, 1949 and 1982, all bear market ends where the Q ratio hit 0.3).
To be sure, economics is not an exact science, and we will always find anomalous scenarios in the markets because they are fluid and driven by psychology more so than anything. That being the case, we can find enough common characteristics such that it is relevant to compare historical trends and to use those comparisons as a component of our current analysis and projections.
Tobin and Napier’s analysis should not be overlooked, and it should temper our investment decisions and entrance points based on valuations. The Q ratio doesn’t take into account growth expectations, and is totally focused on existing balance sheet items. So it gives a pretty strong sense of what a stock or the what the market is worth in a vacuum. But markets do tend to be forward looking, by their very nature.
In which case, it seems to us that if you can find companies closed to the low historical range of the Q ratio, which are also reasonably expected to experience stronger than average growth in the future, you have found a company that will outperform over a certain period, until its growth contracts or the Q ratio gets too close to the peak of the broader markets historical Q ratio range (pace 1999).
This seems like a lot of work, but it really isn’t. We have been talking for weeks now about how companies are getting closer to book value, trading at an increasingly lower ratio relative to cash and cash equivalent, or trading at an increasingly low PEG or PE ratio, and even P/S ratios. These are all important metrics, in addition to the Q ratio for getting a better sense of where to choose entrance and accumulation levels for stocks. We highly recommend them.
