Tobin's Q

Business corporations raise investment funds through share market rather than borrowing from bank.

Selling shares to the public has become a prominent method of raising capital, especially for big business corporations.

• 3/4 of Industrial finance in India is raised by issuing shares. (The rest 1/4 acquired through bank loans)

According to James Tobin, a Nobel Laureate in economics

• Firm’s investment decision is based on market value of the company shares.
• His theory states that the higher the share price, the more the market values the company’s future prospects. This gives the firm more confidence to invest in newer projects and increase its profit opportunities. Thus, the total investment in the company increases with its profits.

How much to invest? This decision, according to Tobin’s Q theory can be taken by computing the Q-Ratio:

$$q=\frac{\text{Market value of Installed Capital}}{\text{Replacement cost of Installed Capital}}$$

Tobin’s Q Theory of investment

Investment decisions are taken on the basis of the ratio of market value of installed capital to the replacement cost of installed capital.

• Market value of the firm / installed capital / assets is determined by the stock market. Market value represents the current worth of a firm’s assets in the open market.
• Replacement cost of capital / assets refers to the expense a company would incur It had to replace or reproduce its existing assets at the present market prices.

IRL, its really difficult to estimate the replacement cost of total assets. Thus, we use a modification of the original formula that replaces the replacement cost with the assets’ book values.

$$Q=\frac{\text{Equity Market Value}+\text{Liabilities’ Market Value}}{\text{Equity Book Value}+\text{Liabilities’ Market Value}}$$

For the overall market, the Q ratio can be calculated as:

$$Q=\frac{\text{Value of stock market}}{\text{Corporate net worth}}$$

Interpretation of Tobin’s $Q$

Case	Interpretation
$Q>1$	Market value assets $>$ their replacement costs, which implies that the firm can create value through investments, and the firm’s management is making efficient use of its assets.1
$Q<1$	The assets are undervalued or used inefficiently, implying that the firm is not using its assets efficiently or overinvesting in assets relative to the perceived market value.
$Q=1$ (theoretical)	the assets are valued ideally.

Tobin’s $Q$ theory of Investment

The firm needs money for investment. This money can be raised either by borrowing or by selling shares, equity, etc.

When the firms sells the share, the buyer buys the share to earn a capital gain from the increase in the market value of the shares.

During Boom:

The share price is high. The firm by selling only a few shares can raise a lot of money. Thus, firms are willing to share equity to finance investment when the stock markets are high.

• if $q$ ratio is high, share price is high. Firms will invest more, they’d buy physical capital, i.e. add to the capital stock.

Reason:

For every Rupee worth of new machinery, the firm can sell the stock for $q$ rupee to finance it and still be left with a profit of $q-1$. In other words, when $q>1$, the firm finds it profitable to acquire additional capital because the (market) value of the capital exceeds the cost of acquiring it². Thus, investments increase.

Transclude of Tobin's-Q-2024-11-02-16.38.44.excalidraw

In the short run

When the demand for desired capital increases from $K_0$ to $K_1$, the demand curve of capital shifts to the right from $D{D}_0$ to $D{D}_1$, increase in demand leads to an increase in price of capital from $P_0\to P_1$

Footnotes

1. People value the company more than it is actually valued. ↩

2. Think for every small thing you do, people appreciate you more than what you deserve… Burn ↩