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Definition: Tobin’s Q Ratio
James Tobin, Nobel laureate in Economics from Yale University hypothesized that the replacement value of all companies in the stock market should be equal to their market valuations. This was the General Equilibrium Theory or Q Theory. He defined Q ratio as the ratio of market value of the firm to the total asset value of the firm (for a single firm). In case of aggregate corporations, Q Ratio is the ratio of stock market value to the total net worth of corporations.
Undervalued stock (Asset value of the firm far exceeds the current market valuation)
Market value of the company justifies the recorded asset value of the company
Higher than 1
Overvalued stock (The firm is trading at a higher market price than its total asset value)
Implications of Q Ratio: If Q (representing equilibrium) is higher than one, then the firm would be an attractive investment option since the profits generated would exceed the firm’s asset costs. Similarly, if Q is less than one, the firm can try selling its asset than spend more on them.
The following graph represents the Q ratios from 1900 to the present, extrapolating the Z.1 data by factoring monthly closes on Vanguard Market ETF.