What is Q Ratio?
Q Ratio, or Tobin’s Q Ratio, is a ratio between a physical asset’s market value and its replacement value. The ratio was developed by James Tobin, a Nobel laureate in economics. Tobin suggested a hypothesis that the combined market value of all companies on the stock market should be about equal to their replacement costs. The ratio can be used for valuing a single company and even the whole stock market.
Formula of Q Ratio
The original formula for Q Ratio is:
However, in real life, it is very difficult to estimate the replacement costs of total assets. Thus, there is a modification of the original formula, in which the replacement costs of the assets are replaced with their book values.
The Q Ratio can be calculated for the overall market:
Applications of Q Ratio
Q Ratio is widely used to determine the value of a company. If the ratio is greater than 1, the market value of a company exceeds the value of its booked assets. The company is overvalued as the market value reflects some unmeasured or unrecorded assets. A ratio greater than 1 indicates that a company’s earnings higher than the assets’ replacement costs. The fact can attract potential competitors who would try to re-create the business model to achieve some of the profits.
When the ratio is lower than 1, the value of the company’s booked assets exceeds their market value. It implies that for some reasons, the market undervalues the company. In such case, the company may be attractive to potential purchasers who would be willing to buy the company instead of creating a similar company.
The ideal scenario is when the Q Ratio equals 1. It suggests that the market fairly values the company’s assets.
However, the ratio significantly depends on the precision of the values recorded by accountants. Two major items can substantially impact the value but frequently cannot be precisely recorded by accountants:
1. Market speculation
Market speculation and market hype often influence a company’s value but they cannot be recorded by accountants. Events such as an analyst’s view on the company’s prospects or rumors around the business can change the market valuation but are not reflected in the company’s records.
2. Intangible assets
Intangible assets such as intellectual property or goodwill can be challenging to measure and record. Generally, accountants record only a rough estimate of intellectual property or goodwill. Thus, an analysis of a company’s value using the Q Ratio should be adjusted for the abovementioned items.
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