Every once and a while a ‘new’ metric comes along that becomes the topic du-jour in the investment community, telling investors why markets are about to crash and how they are clearly overvalued according to metric ‘X’. Aside from the issue that there will always be some measurement somewhere telling investors that it is time to sell, these are often metrics that no one has heard about for years and all of a sudden become the one item an investor should focus on. Last year it was the Shiller CAPE (cyclically adjusted P/E ratio) and this year it looks like it is the Tobin's Q ratio.

So what is Tobin's Q? There are actually two ‘Q Models’, the Equity Q and Tobins Q. Both ratios are quite similar to a price to book ratio where a ratio above one indicates overvaluation and below one indicates an undervalued market. The formulation of the Tobin's Q is the sum of the market value of equity and market value of debt divided by the replacement cost of assets, or (MV Equity + MV Debt)/Replacement cost of assets. Within a similar vein, the equity Q is the market value of equity divided by the replacement cost of equity or, MV Equity/(RC assets – RC liabilities). The similarities between these ratios and book value can be seen but there are differences between book value ad replacement cost which create some complications for the Q models

Q Model Pros and Cons:

The Q models offer an easy to understand ratio that tends to mean revert as it becomes more extended in either direction. It is also tied to economic rationale, given that the higher an asset is priced relative to the cost, the more overvalued it should be. So intuitively, the ratio makes sense. Some downsides are that under or overvaluations can persist for long periods of time. So even though a ratio may be indicating a certain valuation, there is no promise that it will revert in a certain amount of time. The other big con is that replacement costs are hard to estimate. This becomes an even larger problem as economies become increasingly knowledge based. Ten years ago when industrial companies dominated markets, determining what it would cost to replace a plant or capital equipment was a bit easier. Determining what it costs to replace intangible assets like brand names and intellectual property becomes a bit more difficult. This is a big reason why we are not huge fans of price to book ratios as well. They were very useful once upon a time and can be helpful for a preliminary look at a valuation but have less value beyond a bird’s eye view of a company or market.

Grains of Salt:

In our Q&A section, when news flow of this new valuation metric was making its way through the media we had an influx of questions asking about whether it was time to sell and if markets were overvalued. We think an important lesson here is that there are always going to be signs of overvalued and undervalued markets but the key is to try to look at a basket of these metrics and the underlying fundamentals that may be leading to such valuations. Investors often get tunnel vision toward single values. The focus should really be on what various valuations are saying and why they are saying it. Yes, it is much easier and sexier to be able to cite a single metric that is a clear indication of when to sell but the reality is that there is never a simple answer and we can’t rely on any single calculation to give us a reliable answer for, well, anything.