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.

The Q Ratio and Stock Market Valuations

Updated January 26, 2016

Way back in June, I posted a brief article on Tobin's Q, a measure that gives us a good idea of whether stock market valuations are fair.  Here is an update with more recent data.

As background, Tobin's Q (aka the Q Ratio) was developed by 1981 Economic Nobel Laureate James Tobin, who spent his academic career at Yale University.  In 1961, he was appointed as a member of President John F. Kennedy's Council of Economic Advisors and also acted as an advisor to presidential candidate George McGovern when he ran against Richard Nixon in 1972.  Interestingly, Tobin believed that government regulation often resulted in economic damage and argued that one cannot predict the impact of central bank monetary policies on output and unemployment by knowing the rate of growth of the supply of money or interest rates, rather, monetary policy has its impact on the economy through its impact on capital investments in plants, equipment and consumer durables.

Tobin introduced the concept of Tobin's Q as a measure to predict whether capital investment will increase or decrease with Q being the ratio between the market value of an asset and its replacement cost.  In its most basic form, he 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:

    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, I defer to an explanation by Andrew Smithers, the founder of Smithers & Co:

"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%, while the long-term real return to investors is around 6.0%. 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 December 10, 2015.  This 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 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:

Right now, Tobin's Q sits at 0.93.  This is well above the 65 year average of 0.71 if we use FRED's data back to 1951.  As well, while Tobin's Q is down slightly from its post-Great Recession high of 1.11 seen back in early 2014, it is still significantly higher than it has been going all the way back to 2002.

An interesting analysis of Tobin's Q/Q Ratio can be found on Vanguard's website.  As the author, Jill Mislinski notes, the Federal Reserve's Z.1 data is over two months old when it is released to the public.  As such, she uses the Vanguard Total Market ETF as a surrogate for the Corporate Equities Liability Level.  With this data, she calculates that Tobin's Q is currently sitting at around 1.0.  As I noted above, the current Tobin's Q is substantially above the average over the past six decades.  If we use Ms. Mislinski's data to go back further to 1900, Tobin's Q averages 0.68 over the 125 year period.  If we compare all Q Ratios to the arithmetic mean of 0.68 (the solid horizontal black line on the graph), we come up with this graph:

Currently, Tobin's Q is sitting at 45 percent above its long-term average.  While this is substantially lower than the peak of 136 percent during the tech sector bubble of 2000, it is still among the highest levels seen over the past 125 years.

As I noted at the beginning of this posting, Tobin's Q is another indicator that can be used to measure whether the stock market is fairly valued or not.  While the corrections of the past few months have somewhat reduced stock overvaluations when they are measured using the Tobin's Q yardstick, it is quite clear that the ratio is telling us that it is still "caveat emptor" when it comes to equities.  Perhaps all of that “newly minted” Federal Reserve “money" has found a warm welcome in America's equity markets, pushing equity prices to unrealistic values.

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

Updated August 17, 2015

In the 1960s, 1981 Economic Nobel Laureate James Tobin developed an interesting measure which gives us a sense of stock market valuations and whether the stock market is overvalued or fairly valued.  The ratio was developed based on Dr. Tobin's hypothesis that companies should be worth what it costs to replace them, in other words, the total stock market valuation of a company should not exceed the value of its assets.  The ratio, known as Tobin's Q, is the ratio of price to replacement cost; in its simplest terms, it measures a firm's assets to its market value as calculated using this formula:

            Tobin's Q = Total Market Value of a Firm  

                                Total Asset Value of a Firm

It can also be thought of as the ratio of the market value of a company's installed capital to the replacement cost of the installed capital.

Here is a very simplified example.  If a company has $40 million of assets, 10 million shares outstanding and a share price of $3.00, Tobin's Q would be calculated as follows:

          Tobin's Q = (10,000,000*$3.00)/$40,000,000 = 0.75

When Tobin's Q is between zero and 1, it costs more to replace a company's assets than the firm is worth (on the stock market).  If Tobin's Q is above 1, the firm (on the stock market) is worth more than the value of its assets.  Theoretically then, if Tobin's Q is greater than 1, a company is overvalued and if it is less than 1, it is undervalued.  If we look at the aforementioned example company, leaving its assets at $40 million and its outstanding shares at 20 million and increase its share price to $5.00, Tobin's Q would be calculated as follows:

         Tobin's Q = (10,000,000*$5.00)/$40,000,000 = 1.25

This means that the example company is overvalued when the stock price rises to $5.00 per share. according to Tobin's theory. 

Tobin's Q can be taken to the extreme, covering the entire United States corporate universe by using the quarterly Federal Flow of Funds data from the Federal Reserve's Z.1 Financial Accounts of the United States which you can find here.  If you go to table B.103, Tobin's Q can be calculated by dividing line 39 (market value) by line 36 (replacement cost).  Tobin's Q generally hits highs during bull or bubble market phases and drops to lows during recessions and bear market phases.    

The Tobin Q ratio can be calculated using data on the FRED website by dividing Non-financial Corporate Business Corporate Equities Liability Level by Nonfinancial Corporate Business Net Worth Level which will result in this graph:

The data used in this calculation is gleaned from the Federal Reserve Z.1 Statistical Release Financial Accounts of the United States which is released on a quarterly basis. 

Looking all the way back to 1950, the mean Q ratio is 0.71 and going back further to 1900, the  mean is 0.68.  Right now, the Q ratio is 1.069, just below its post-Great Recession peak of 1.89 in the second quarter of 2014.  You will also notice that, while the Q ratio is below its post-1950 peak of 1.64 that was experienced during the tech sector bubble of the late 1990s and early 2000s, it is just below the second highest level seen since 1950 and, if we go back in history to 1900, the Q ratio is above any peak since that time.  It has also risen significantly from its low of 0.57 during the depths of the Great Recession. 

If we look at the Q ratio and divide it by the average over the last half century, at the tech sector peak, the market price was about 131 percent above the historic average of replacement cost.  Right now, the latest data point is 49 percent above the mean, suggesting that the stock market is significantly overvalued.  It is important to keep in mind that periods of stock market over- and under-valuation can persist for many years at a time (as happened during the tech sector bubble),  however, the current high level of Tobin's Q suggests that the stock market is likely to change direction significantly over the medium- and long-term.