# Tobin's q

Tobin’s q is the ratio of market value of a company’s assets to the replacement value of those assets. The market value of assets can be estimated as the sum of market value of the company’s equity and book values of its debt and the replacement value can be considered as equal to the book value of total assets.

Tobin’s q measures the wealth generated by a company for its shareholders. It compares how much more a company is worth when compared to the book value of its assets. Any excess of market value of assets over their book value results from intangible assets, goodwill, future growth potential, competitive position, etc.

A high q ratio is generally considered good because it indicates that the company is worth more than the sum of its assets. But since it is based on historical data, it is not a good predictor of future returns on the company’s equity. In valuation context, a high q ratio might indicate that the company’s stock is overvalued. The Tobin’s q ratio can also be utilized as an indicator of overall stock market valuation. A very high ratio relative to historical trend might indicate that the stock market is overvalued and vice versa.

## Formula

Tobin’s q can be calculated using the following equation:

$$ Tobin's\ q=\frac{Market\ Value\ of\ Assets}{Replacement\ Value\ of\ Assets} $$

Market value of assets equals the market value of equity and market value of debt. The actual replacement value of assets is hard to determine so it is assumed to be equal to the book value of total assets:

$$ Tobin's\ q\ =\frac{E_{MV}+D_{MV}}{A_{BV}} $$

However, many companies do not have marketable debt, so it is assumed that the market value of debt equals its book value. So Tobin’s q simplifies to:

$$ Tobin's\ q=\frac{E_{MV}+D_{BV}}{A_{BV}} $$

Where **E _{MV}** is the market value of equity (i.e. stock price multiplied by total number of shares outstanding),

**D**stands for book value of debt and

_{BV}**A**is the book value of total assets.

_{BV}## Example

Given the following data, calculate the Tobin’s q:

Item | Company A | Company B |
---|---|---|

Stock price | $20.00 | $40.00 |

Number of shares outstanding | 12,500,000 | 5,000,000 |

Market value of debt | $375,000,000 | $- |

Book value of debt | $360,000,000 | $260,000,000 |

Book value of equity | $225,000,000 | $225,000,000 |

Only Company A has market value of debt available, so we should use the Tobin’s q formula which uses book value of debt to work out the ratios.

$$ Tobin's\ q\ (Company\ A)\\=\frac{$12,500,000\times$20+$360,000,000}{$225,000,000+$360,000,000}\\=1.04 $$

Using the same formula, Tobin’s q for Company B works out to 0.95.

The analysis shows that Company A has performed better in adding shareholders wealth as compared to Company B. However, it doesn’t mean that Company A will continue to perform well. There is a possibility that Company A is overvalued and Company B is undervalued.

Written by Obaidullah Jan