Valuation of equities - Tobin’s q ratio

Question 1

Define Tobin’s q. (2 marks). Outline the uses of the q ratio. (3 marks)

Answer 1

The Market Value of the entire stock market is equal to its replacement costs
1> take over target
1< Will see and increase in compertition
Quick judgment of value

Question 2

Why do you think Tobin’s q ratio and Shiller’s p/e ratio (based on 10 year trailing earnings of companies) move in a very similar fashion? (5 marks)

Answer 2

Both look at whether a market is over or under valued.

both are mean reverting

Question 3

How will a fall in long term interest rates likely affect the level of q? (2 marks) What will be the main impact and why? (3 marks)

Answer 3

Investment will be higher

Replacement costs get lower as the cost of borrowing to replace is lower. this will mean 1< and should increase competition

Question 4

Tobin’s Q: Advantages & Disadvantages

Answer 4

Advantages - quick judgment of value Disadvantages - how to deal with intangibles (difficult to determine replacement costs) - breakthroughs in productivity destroy value of existing stock