Q Ratio (Tobin's Q Ratio)

Oh, the classics. Gone with the Wind...Psycho...the supply and demand graph.

Think of the supply and demand curves for a minute. Where they cross is equilibrium: the point at which quantity and price are both an option for the suppliers and the demanders. Understanding Tobin’s Q ratio is similar.

The Q ratio—Tobin’s Q—is an equilibrium for a firm when it equals "one." It’s where the firm’s market value (what it could sell for) equals the firm’s assets’ replacement cost (how much it would cost to replace all company assets).

Sound like hogwash? Only if the Nobel Prize also sounds like hogwash. James Tobin, Nobel laureate in economics, came up with the Q ratio. It all started when Tobin expressed his belief that the total value on the stock market probably equals the total replacement costs on the stock market. Using this theory, you can use the Q ratio on an individual firm to try to determine if it is undervalued, overvalued, or at equilibrium. There are a few ways to calculate the Q ratio, since the latter figure is hypothetical, but here's a common one: total market value divided by total asset value.

A Q ratio of one means everything’s balanced. Higher than one means there’s more market value than asset worth, which signals that it's being potentially overvalued. On the flip-side, if the Q ratio is under one, it means the market value is lower than the asset value, which implies the market is undervaluing the firm.

Hey, every firm just wants to be treated with the respect it deserves.