What is a Q Ratio?

The Q ratio is a measure of how overpriced or underpriced the whole stock market is. It is based on Tobin's Q, which measures a firm's assets in relation to its market value. The formula for Tobin's Q is:

Tobin's Q = Total Market Value of Firm/Total Asset Value of Firm

Likewise, the formula for the Q ratio is:

Q Ratio = Total market value of all companies in stock market/Total asset value of all companies in the stock market

How Does a Q Ratio Work?

James Tobin, a Nobel Prize winner in economics and a professor at Yale University, developed the ratio after hypothesizing that companies should be 'worth' what they cost to replace. The data for the Q ratio typically exists in the Federal Reserve's quarterly Flow of Funds Accounts reports.

Why Does a Q Ratio Matter?

When the Tobin's Q ratio is between 0 and 1, it costs more to replace a firm's assets than the firm is worth. A Tobin's Q above 1 means that the firm is worth more than the cost of its assets. Because Tobin's premise is that firms should be worth what their assets are worth, anything above 1.0 theoretically indicates that a company is overvalued.

When applied to the entire market, as the Q ratio is, anything above the mean Q ratio indicates that the market is generally overvalued (and that it might be time to invest in something besides stocks); anything below the mean Q ratio indicates that the market is generally undervalued (and now might be the time to shift away from other asset classes).

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Paul Tracy

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