Looking for an indicator of market value? Tobin's Q ratio may help.
We all want to buy shares when the stock market is relatively undervalued, or at least avoid buying them when the stock market is peaking!
One of the most important tools for identifying an overvalued or undervalued stock market is Tobin's Q ratio. The attraction of this indicator is that it has both commonsense rationality and a good success rate.
How it works
The Q ratio was developed by the late James Tobin, a highly rated economics professor at Yale university. Highly rated is perhaps an understatement: James won a Nobel Prize for his influential work on financial markets.
The Q ratio relates the market value of a company (or all companies) to the cost of replacing all its assets. For example, if a company has a market value of £1bn and the cost of replacing all its assets are £500m, the Q ratio is 2 and it would be considered overvalued.
Why buy the company on the stock market for £1bn when the cost of building it from scratch is £500m? Switch the numbers around and the company would be clearly undervalued. If you can buy it for £500m on the stock market when building it from scratch would be £1bn, then the Q ratio would be 0.5.
So, to calculate the Q ratio you divide market value by asset value: Q = Total Market Value / Total Asset Value
As usual there are caveats, but the long-term average ratio has been 0.6, peaking at nearly 2 in the year 2000 at the height of the bull market. It's fallen to 0.3 at bear market lows.
Of course, the equation looks easy but obtaining the necessary data can be devilishly difficult. Fortunately, as far as the US market is concerned,the Federal Reserve does most of the work for you. The numerator (market value of equities) and the denominator (net worth) can be found in its quarterly 'Flow of Funds Report'.
For further reading, one of the best books on the Q ratio and its practical use in investment is 'Valuing Wall Street' by Andrew Smithers. He wrote it at the height of the last bull market and predicted a fall of 50%.
How useful is the Q ratio?
Supporters of the Q ratio claim it has signalled every bear market low (1921, 1932, 1949, 1974, 1982). I'm always a bit sceptical about the usefulness of that kind of claim. For example, at the moment the "perma-bears" of the Q theory are claiming that the Q ratio always bottoms at 0.3. As it currently stands at 0.72 they expect markets to drop by another 50%+.
Meanwhile Bill Goss (CEO of PIMCO, an investment firm with $790 billion of assets) says: "The Q ratio has never been lower...implying extreme undervaluation.."
I tend to take a bit more of a balanced view, and would agree with John Mihaljevic (who worked with Tobin) that the best proven strategy has been to buy when Q is below 0.4 and sell when it is above 1. I reckon the current figure is 0.72, signalling that the market is fair value.
It's not without its detractors
There are two main objections to the rationale behind the Q ratio. The first is that the economy has changed and that many of the new companies in IT and the service sectors do not rely on tangible assets. They depend more on people and intellectual property so a measure based on asset value is skewed toward the old economic sectors like manufacturing.
The second reservation is that economic value is not a function of total assets but rather the long-term cash flows generated by those assets. This is to some extent covered by the cyclically adjusted P/E ratio, which I looked at earlier this week.
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