Tobin’s Q theory of Investment which is written as Tobin’s Q or simply Q. Most times, it is called Tobin’s Quotient since the Q stands for Quotient. Fewer attimes, people call it the brain of Tobin’s Q.
Tobin’s Q is the ratio between a physical asset market value and the replacement value. Tobin’s Q theory of investment is that which links a firms investment decisions with fluctuations in the stock market. It was introduced in 1968 by the Nobel Prize Winner in Economics James Tobin and William Bernard although the use of the letter Q did not appear until Tobin’s 1969 article titled “A General Equilibrium Approach to Monetary Theory”.
Tobin writes that the numerator is the Market value while the denominator is the replacement or reproduction cost.
To explain further, the Market value is the price for which something (shares) can be sold in a given market (stock market).
Replacement cost is the amount that an entity would have to pay to replace an asset at a present time, according to its current worth. For example, when a television is covered by a replacement cost value policy, the cost of a similar television which can be purchased today determines the compensation amount for that item.
Given below is the formulae for calculating the Tobins Q ratio;
Q = Market Value of Capital Stock
Replacement Cost of Capital
Example
Let the Market value of capital stock take the values of ₦10,000, ₦20,000 and ₦5,000 while the replacement cost of capital should take the value of 10,000. We calculate as follows;
When Market Value of Capital Stock is ₦10,000
Q = ₦10,000 = 1 thus, Q=1
₦10,000
When the Market Value of Capital Stock is ₦20,000
Q= ₦20,000 = 2 thus, Q>1
₦10,000
When the Market value of Capital Stock is ₦5,000
Q= ₦5,000 = 0.5 thus, Q<1
₦10,000
Illustration
The graph below should serve as an assumed illustration of Tobin’s Q for all Nigeria’s Corporations. The undulating line shows the ratio of Nigeria’s stock market value to its Nigeria’s Net assets.
Application;
If Tobin’s Q is equal to 1.00 (Q=1.00), it means that the market value reflects completely the recorded assets of the company.
If Tobin’s Q is greater than 1.00 (Q>1.0), it means that the market value represents some unrecorded or unmeasured assets of the company. High Tobin’s Q values encourage companies to invest more in capital because they worth more than the price they paid for them.
If Tobin’s Q is less than 1.00 (Q<1.00), this will discourage companies from investing in shares as they will earn less.
The diagrams below show how an increase in Tobins q induces a rise in the firms new investment. It illustrates that an increase in the demand for shares raises their market value which raises the value of q and investment.
The demand for capital is shown by the demand curve D and D1 in panel (A). The relative value of Q is taken as unity as the market value and replacement cost of capital stock are assumed equal. The initial equilibrium is determined by the interaction of demand and the available supply of capital stock OK at point E, which is fixed in the short run. The demand for capital depends mainly on two factors.
First, the level of wealth of the people. The higher the level of wealth of the people, the higher shares people wish to have in their wealth portfolio.
Second, the real return on other assets such as government bonds or real estate. A fall in the real interest rate on government bonds would induce people to invest in shares than in other forms of wealth.
Implications of Tobin’s q;
There are two important implications of Tobin’s q theory which are;
- Incentive to invest: Tobins q ratio provides an incentive to invest for firms on the basis of the stock market. It not only reflects the current profitability of capital but also its expected future profitability. Investment is expected to be higher in the future when the value of q is larger than 1. Tobins q theory of investment induces firms to undertake net investment even when q is less than 1 in the present. They may adopt such economic policies which bring future profitability by raising the market value of their shares.
- Valuation of Corporate Profits: Since the most important source of movement in q is the change in stock market prices, Tobin’s theory creates an additional channel by which changes in the stock market may influence the economy through its effect on the attractiveness of investment.
Tobin’s theory also makes a major breakthrough in the area of investment behaviour. There is no need to guess how business firms make calculations about their expected future profits and how these expectations respond to economic events. Instead one has simply to look to the stock and bond markets for the necessary valuation of the firm’s future stream of profits.
Criticisms of Tobins q;
Some of the criticisms of the Tobin’s Q theory of investment are;
- Tobins Q is not a valid market timing metric.
- Tobin’s Q does not measure a firm’s performance.
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