How usefull is the Q Ratio

John Creighto

How important is the q-ratio?

More sober and historically reliable measures of market valuation create a much more challenging picture. Apart from our own measures, which indicate continued overvaluation, there are several good indicators of market valuation that are not overly sensitive to year-to-year fluctuations in profit margins. One is based on the 10-year average of actual net (not operating) earnings, which is advocated by economist Robert Shiller, and another is Tobin’s "q" ratio which is based on comparing market value to replacement cost, and is advocated by Andrew Smithers. Both of these measures largely agree with our own measures, both presently and on a historical basis. Based on last week’s valuations, both suggest that the S&P 500 is substantially overvalued.

Read more: http://www.creditwritedowns.com/2010...#ixzz0uLmVvAe9

I'll agree that if the company can be replaced at a lower cost then buying it's stock then it is likely over valued. I will also agree that if the price to earnings isn't so hot the Q-ratio is perhaps another good measure to look at. However, how tangible are the assets of a company. The company includes more then just buildings and machinery. It also includes, people, trade secretes, patents, work processes, brand value and business contacts. I'm sure some of these things are included in the value of the companies assets but recreating the company is not always an easy process. It requires a pool of labour which includes the right skills and expertise to draw from.

loseyourname

I think exactly what you said is the problem with this method of valuation. It's the reason managers are often evaluated based on market value added, that is, the excess of a company's market value to its book value (which is just the historical form of replacement cost).

Replacing all of a company's physical assets is not the same as replicating its productivity and expected return. Even replicating intangible assets doesn't do that. Take McDonald's franchises, for instance. They're all physically identical and possess the same intangible assets (recipes, public goodwill), but they still don't generate identical returns.

Share value isn't a function of asset replacement cost for that reason; it's a function of expected future free cash flows. Human decisions, not just tangible and intangible assets, drive those.

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