Wednesday, December 30, 2015

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.


  1. Thanks for another great article, sadly it paints a troubling outlook going forward. The much loved theory that we will be able to grow our way out of our difficulties and muddle through is a bit simplistic and much overused. Artificially low FED controlled interest rates are a massive "one-off" or onetime tailwind that should be considered mainly behind us. The article below delves into why such a policy is bringing diminishing returns.

  2. What we have had is the baby boomers with their wild spending and Keynesian economics trying one last fling. What we are entering is an era where Nex geners (ie Trudeau) will be controlling the economy. What we will have is caretaking - no efforts to move forward, an era of unimaginative money management with little risked, little done and many self serving directions. It will be short because the Millennials will steal the stage with their social activism and collective effort. Q will continue to drop sometimes in big slides because of disasters, natural or financial, but never turning upward strongly until the Millennial's take charge.

  3. Ultra low fixed returns would increase this Q ratio and I don't see fixed runs raising any time soon.

  4. Ultra low fixed returns would increase this Q ratio and I don't see fixed rates rising any time soon.