Saturday, January 02, 2016

Tobin's Q Below 1.0 In Q3 2015

As of the third quarter the Tobin's Q ratio declined below 1.0. The Tobin Q ratio was originally formulated by Yale University professor James Tobin. James Tobin is a Nobel laureate in economics. The theory behind the ratio is the combined market value of companies on the stock market should be equal to the replacement cost of company assets. The Q ratio is defined as the ratio of the market value of a firm to the replacement cost of its assets. When the stock market trades at a ‘discount’ to the replacement cost of its assets, the market is inexpensive. This discount is when the ratio is below 1.0. When the ratio is above 1.0, the market trades at a premium to its replacement cost. As the below chart shows, this reading below 1.0 is the first since the Q ratio equaled .986 at the end of Q2 2013.

From The Blog of HORAN Capital Advisors

Since 1990 the average Q ratio level is .94, but certainly skewed by the high Q reached at the height of the technology bubble in 2000. Going back to 1950, the long run average Q ratio is approximately .70. The Tobin Q ratio is not a short term timing indicator; however, it does allow one to evaluate over and undervaluation of the market. In terms of expected returns, the below chart shows future 10-year forward returns at various Q levels. Evident from the chart is lower Q levels are associated with better forward returns.

From The Blog of HORAN Capital Advisors

What are the implications with "Q" values greater than or less than 1.0,? According to the website, Money Terms,
"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."

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