What is Tobin's Q Ratio?

The Tobin's Q ratio is a measure of firm assets in relation to a firm's market value. The formula for Tobin's Q is:

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

How Does Tobin's Q Ratio Work?

For example, let's say Company XYZ has $40 million of assets, 10 million shares outstanding and a current share price of $3. Using the formula, we can calculate that Tobin's Q is:

Tobin's Q = (10,000,000 x $3) / $40,000,000 = 0.75

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.

Why Does Tobin's 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.