Tobin's Q - Application

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 of expected profits.