Tobin's Q

Tobin's Q compares the market value of a companies' to the replacement value of their tangible assets:

Q = market value ÷ replacement value

The market value of a company is the total market value of its debt and equity. Economist James Tobin hypothesised that the combined market values of listed companies should approximately equal their combined replacement cost.

A Tobin's Q of more than one means that the market value of assets (as reflected in share prices) is greater than their replacement cost. This means it is likely that capex will create wealth for shareholders. This means companies should increase capex, raising more money to do so if necessary, but should not make acquisitions. This should reduce share prices and increase asset prices, pushing Q towards one.

A Tobin's Q of less than one suggests that the market value of the assets is less than replacement cost, making acquisitions cheaper than capex; buying cheaper than setting up from scratch. This should increase share prices and reduce asset prices, again pushing Q towards one.

The validity of Tobin's Q at the level of individual companies is, at best, questionable, although it may be useful in mechanical investing strategies, especially when combined with other measures. There are better ways of valuing companies. It is more interesting at market level. Among other things, it may explain the value effect.

Other metrics used to look at the whether the market as a whole is correctly valued include the cyclically adjusted PE, which is often used in conjunction with Tobin's Q.

Copyright Graeme Pietersz © 2005-2019