Q Ratio

This is a ratio devised by James Tobin Yale University in the late 1960’s and looks at the total value of a firm on and the total value of its assets - in its simplest for the ratio is calculated as follows:

Q Ratio = Total Market Value of a Firm

Total Asset Value

So if a firm has 100m shares and a price of £2.75 is has a market capitalisation of £270.5 million; this is the total market value of a firm i.e. what investors are willing to pay for ownership of a share of a Company.

If the total assets of the same Company - this includes all things such as property, equipment, cash at the bank etc - is £200m then the Q Ratio for the company is

Q Ratio = £270.5m     = 1.35

£200m

The market is valuing the Company at 1.35 time the cost of its assets; if this ratio was less than 1 then the market could potentially be undervaluing the Firm.

This ratio can be applied and interpreted in many ways; it can be used to assess a Company, a sector or the market has a whole. To use the ratio effectively as a gauge its important to understand how changes in the numerator and the denominator  effect the ratio—for example market speculation and aggressive stock buying can increases the market value raising the ratio. When it comes to total assets what’s not included? Things such as brand name and intellectual property (intangibles) are difficult to value and a high Q ratio could be justified because of the value of these items that do not make up the total assets.

As with any indicator the best thing to do is test it! Over a decent period of 10 or more years……...

The graph below shows the Q Ratio (blue) of a share we looked at recently, the red graph is inverted and shows subsequent three year returns - the patterns are fairly similar and since 2004 a high Q ratio led to disappointing returns over the next 3 years whereas the low Q Ratio in 2009 set the scene for a excellent returns. In late December 2013 the ratio peaked at 1.30 and provided an early warning indicator as the next 40 days saw the price decline by almost 25%. As with all indicators its not perfect, and we never rely on one alone.