The June 2011 Federal Reserve Flow of Funds report is out. Before I get to the calculation of Tobin’s Q I’ll take a brief detour to explain what Tobin’s Q is and why it is of use for investors.
What is Q?
Q = Stock Price / Corporate Net Worth per Share
Economic Nobel laureate James Tobin wrote about the Q ratio back in the 1960s and now Andrew Smithers of Smithers & Co., Ltd., continues on the tradition with his research firm. In essence it is a simple way to measure whether the stock market is under or over-valued based on the replacement value of the entire stock market. Market valuation is determined from the relationship of the current value of Q to its measurement of fair value.
Why use Q?
The main reason to use any metric of value is whether or not it mean reverts; the Q ratio does mean revert to its measurement of fair value. The Q ratio is a statistical measurement of the market’s value and this usually means fair value should be 1 however, with the Q ratio, Andrew Smithers and Stephen Wright have found that with Q fair value is equal to 0.65. Andrew Smithers and Stephen Wright, in their book “Valuing Wall Street : Protecting Wealth in Turbulent Markets
Another reason to use any measurement of fair value is the metric’s hindsight value or its historical ability to predict when the market is under or over-valued. Again, Smithers and Wright show that amongst all market value measurements tested, the Q ratio has shown the greatest hindsight value (i.e. Over time the Q ratio has reliably shown when the stock market is under or over-valued).
Drawbacks to using Q
Q is not a timing measurement. It is a tool to measure risk in the overall market. The higher the premium to fair value the more risk there is in holding common stocks, while the lower the premium (or greater discount) to fair value the less risk exists in holding stocks. The overall market can stay irrational much longer than anyone thinks possible and Q can continue to climb higher while the market continues to climb. The late 1990s tech bubble is a prime example. The Q ratio signaled an over-valued and very risky market years ahead of the bubble’s top.
Q is not a money making tool. Investors looking at Q as a way to generate alpha will surely be disappointed. Q is a tool to help investors protect capital.
The measurement itself is not timely. As I discuss below, the data needed to calculate Q is from the Federal Reserve’s Flow of Funds report. This report comes out every quarter and by the time it is published the data will already be a couple of months old.
How to measure Q
Q can be calculated using the latest Flow of Funds report from the Federal Reserve. The two line items needed can be found in table B.102. The numerator is line 35 “Market Value of Equities Outstanding (includes corporate farm equities)”. The denominator is line 32 “Net Worth (Market Value)”.
Current Q
Based on the June 2011 Flow of Funds report Tobin’s Q currently resides at 1.03.
How to Trade
According to one of the trading strategies outlined by Smithers and Wright in their book, investors should get out of stocks when Q rises 50% above fair value. Currently Q is 58.5% above fair value.
Remember, Tobin’s Q is not a timing mechanism; it is a measurement of risk. The stock market can continue higher regardless of what any metric of valuation is showing. It is a tool to help shape an overall investment thesis and to separate short-term concerns and long-term concerns.
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