Tobins Q Theory
Tobin’s Q theory was developed in 1968 by James Tobin. Tobin’s Q is a ratio which compares the value of the stocks of a listed entity in the capital market with the value of its equity book value. Usually Tobin’s Q was applied as a method for predicting investment behavior.
Tobin’s Q theory compares the market value of an entity with the replacement cost of its assets. It uses the ratio (Q) to predict the investment decisions of the entity. It is independent of macro-economic conditions such as interest rates. The replacement cost of fixed assets can be calculated as the reported value of a entity’s fixed assets plus the accumulated depreciation and an adjustment for inflation (if any).
As with market-to-book value ratios, Tobin’s Q theory is most revealing when like companies are compared over a period of several years. Use of both Tobin’s Q and the market-to-book ratio are best suited to making comparisons of the value of intangible assets of firms within the same industry, serving the same market, that have similar types of hard assets.
When both the “Q” and the market-to-book ratio of a entity are falling over time, it is a good indicator that the intangible assets of the companies are depreciating. This may provide a signal to investors that a particular entity is not managing its intangible assets effectively and may cause them to adjust their investment portfolios towards companies with climbing or stable “Q” s.
Advantages of Tobin’s Q Theory
An advantage of Tobin’ Q over the market-to-book ratios is that Tobin’s Q approach neutralizes the effects of various depreciation policies.
Tobin’s Q could be an important measure of intellectual capital as it can reflect the value markets place on assets, which are not normally reported in the conventional Balance Sheet.
By making intra-industry comparisons between companies’ primary rivals, these indicators may act as performance benchmarks that could be used to perk up the internal management or corporate strategy of the company.
The information provided by these ratios assists internal benchmarking by enabling the organization to track its growth in the area that it has defined as being integral to its success.