What is Tobin's Q Telling About Stock Market Valuations?

Updated December 11, 2016

Given that I haven't posted on this subject for nearly a year, and given that the United States stock indices continue to rise into the stratosphere despite signs that the economy is not particularly strong, I thought that it was a good time to revisit the concept of Tobin's Q aka the Q Ratio.

Tobin's Q (aka the Q Ratio) was developed by 1981 Economic Nobel Laureate James Tobin, who spent his academic career at Yale University.   Tobin's Q can be used as a measure to predict whether capital investment by businesses will increase or decrease with Q being the ratio between the market value of an asset and its replacement cost.  Basically, Tobin hypothesized that companies should be worth what it costs to replace them.  In other words, the total stock market value of a company should not exceed the value of its assets.  Therefore, the ratio of the total market value of a company is divided by the total asset value of that same company to give us Tobin's Q.  Here is the formula that gives us Tobin's Q:

    Tobin's Q (Q Ratio) = Total Market Value of a Company 

                                        Total Asset Value of a Company

While it seems logical that the Q Ratio would be 1 (i.e. a one-to-one relationship between total market value and total asset value), this is not the case.  Here is an explanation by Andrew Smithers, telling us why the long-term average of the Q Ratio is less than one:

"The long-term average value of Q is below 1 because the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8 percent, while the long-term real return to investors is around 6 percent. Over the long-term and in equilibrium, the two must be the same.  The major cause of over-valuation of assets is almost certainly due to their economic rate of depreciation being underestimated."

If we take Tobin's Q to its ultimate level, it can be used to cover the entire U.S. corporate world by using the Federal Flow of Funds data from the Federal Reserves quarterly Z.1 Financial Accounts of the United States with the latest release on September 16, 2016.  The data used to calculate Tobin's Q can be found on Table B.103 Balance Sheet of Non-financial Corporate Business or on the St. Louis Federal Reserve Bank's FRED database.  Using the Federal Reserve's database, FRED, Tobin's Q can be calculated by dividing Non-financial Corporate Business; Corporate Equities Liability Level by Non-financial Corporate Business Net Worth Level which gives us this graph:

What is interesting to note is what happened to the Q Ratio during the massively overvalued stock market during the tech boom that took place during the end of the 1990s and into the early 2000s.  We all know how that story ended, don't we?  Back to the present, at the end of Q2 2016, the Q Ratio sat at 0.97, 38.4 percent above the arithmetic average of 0.701 when we look at data going all the way back to 1945.  

Unfortunately, as you can see, the data provided by the Federal Reserve is not exactly current, showing us what happened to the Q Ratio only until the end of the second quarter of 2016.  On the Advisor Perspectives website, Jill Mislinski provides us with a more up-to-date look at the Q Ratio using changes in the price of the Vanguard Total Market ETF as a surrogate for the Fed's Corporate Equities - Liabilities value.  As such, here's what the current Q Ratio looks like to the end of November 2016:

According to Ms. Mislinski's calculations, the peak Q Ratios deviated from the 116 year arithmetic mean as follows:

Ms. Mislinski's calculations show that the Q Ratio currently sits at 51 percent above the mean and is now in the vicinity of the range of the historical peaks, excluding the Tech bubble peak.

I can recall during the tech boom when "experts" were telling us that the traditional metrics used to evaluate companies like earnings per share etcetera were no longer valid.  Obviously, that was an incorrect analysis with the Q Ratio clearly showing that valuations returned to (and below) the mean.  With the S&P 500 and Dow Jones regularly flirting with record highs on an economy that is definitely not performing on all cylinders and the Fed flirting with monetary policy "adjustments", the current Q Ratio suggests that we are experiencing stock market valuations that are not sustainable.  History has repeatedly shown that the Q Ratio always returns to the mean.  After all, that's why it's called "the mean.