Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Using Tobin’s Q Ratio To Assess the Market

Monday, July 19, 2010


The Q Ratio has been getting more attention than usual lately (for example, articles by Smithers and Short). Conventional wisdom is that current Q Ratio levels significantly above long-term averages indicate that the market is substantially overvalued. Our view: The Q ratio is an extremely useful metric, but the conventional wisdom on the topic is wrong.

From a practical perspective, equity prices are the biggest input that determines the Q ratio. (The other two components, corporate assets and debt, are relatively stable in comparison.) And equity prices are determined by two variables, economic earnings (Cash ROI) of corporate sector firms, and the discount rate applied to these economic earnings. The proper perspective is to assess the current Q ratio not against some long-term average, but against what the Q ratio SHOULD be given the Cash ROI and Discount Rate currently applicable to the market.

Corporate earnings, Return on Equity, and other conventional performance metrics are inherently volatile. In contrast, the inflation-adjusted (real) Cash ROI for the S&P 500 has been remarkably stable over several decades, ranging between 6%-8% during the 70’s and 80’s, and gradually increasing to the 8%-10% range over the past twenty years.

The warranted real Discount Rate (Cost of Capital) depends primarily on inflation expectations, tax rates, and real interest rates. The combination of high inflation and high marginal tax rates resulted in real discount rates above 10% in the late seventies. Inflation and tax rates over the past ten years would justify a real discount rate of 3.5% to 4%, although the market pricing has reflected discount rates about 200 basis points higher. (One plausible explanation for this discrepancy might be investor assessments that current inflation and tax rates are aren’t sustainable given recent fiscal deficits and long-term funding issues with Medicare and Social Security.)

Back in 1978 inflation expectations were around 6%, with a 70% tax rate on dividends and 42% on capital gains. If you assume a long-term Cash ROI forecast of 7%, then the appropriate Q ratio would have been about .8 times assets. Compare that with today’s economy, where a long-term ROI forecast of 9% is plausible. Even with anticipated tax rate hikes, Ativo estimates that the real (inflation-adjusted) discount rate should be under 4.5%. But let’s be conservative and use 6%. The resulting Q ratio would be about 1.4 times assets.

There are enough measurement and forecast issues that we’re not going to say precisely what today’s Q ratio should be. Our key point is that the right Q ratio benchmark isn’t some long-term average, but rather depends on current economic conditions. Just remember, the full-year average temperature for Chicago is about 50 degrees Fahrenheit. But a 50 degree day in January is balmy, while a 50 degree day in May is freezing. Everything depends on context. It’s the same way when assessing the Q ratio.