In CFAI it says (Vol 3, page 167) that if Tobin’s Q is greater than 1 (assuming 1 is in equilibrium) for a company, the (1) market values the company’s asset at more than their replacement costs, (2) so additional capital investment should be profitable for the company’s suppliers of financing. (3) And later when they talk about the overall market level for Tobin’s Q, if Tobin’s Q is below the comparison value (lets assume it is 1), then it will be undervalued. It is undervalued because “it indicates an opportunity to buy assets at a price below their replacement cost.” And if Tobin’s Q is above the comparison value (1 in this case), then the market is interpreted as being overvalued. My question is, if Tobin’s Q is greater than 1 then statement (2) says those who invest in the company (the suppliers of financing) would be profitable. This would mean that the company is undervalued, correct? And should invest in the company? But if Tobin’s Q is greater than 1 (assuming 1 is the comparison value) in the overall market level, then the market is overvalued?
These are my thoughts: When Tobin’s Q > 1 Market Value of company’s assets is more than that of replacement value So something the company is doing is good. (adding more value) So if an external investor does invest more on assets in the company, assuming the same trend continues, what the company does using those will make more money in the long run for the investor of capital. More Return on Invested capital. Company being undervalued I would think is a far stretch. It is more that Company value is greater than sum of its parts. But when Tobin’s Q < 1 Company is not adding any additional value to invested assets. It’s assets are less useful when as a company, but worth more by itself in the market place. Return on invested capital for a supplier is not going to be as much. So it might make sense not to invest in additional capital here. (Not that the market is overvalued).
Thanks CP, CFAI differentiates Tobin’s q on a company level and on an overall market level. On the company level, it is as what you said. (1) On the overall company level (vol.3 page 167, second paragraph), if market’s Tobin’s q is > the comparison value (assuming it is the equilibrium value of 1) then the market is overvalued. (2) CFAI is stating that if Tobin’s q on the market level is greater than the comparison value (lets assume the comparison value is again the equilibrium of 1), then the market is overvalued. I’m taking the assumption that you shy away from investing in overvalued company(ies). As the companies make up the market, assuming that a majority of the companies uses invested capital efficiently and makes them worth more than the replacement cost (Tobin’s q >1), you would want to continue investing in that company, then wouldn’t Tobin’s q on the aggregate (market level) be > 1 (again, assuming the comparison value is the equilibrium) if most companies in that market is > 1? In the EOC question number 10, the viginette gives an exhibit of a companys asset values etc. etc. and asks you to calculate Tobin’s q and give a conclusion bases on a comparison to an equilibrium value of 1. Now this is on a company level so Tobin’s q > 1 means that the company will produce more from the assets than the replacement cost for those assets --> invest in the company. (3) The answer for question 10 says, paraphrasing, 'Tobin’s q value is less than so that “indicates that the company is undervalued in the marketplace because it indicates an opportunity to buy assets at a price below their replacement cost.” This to me means, you are buying company assets at replacement (market cost) so you should invest in the company. Doesn’t (1) and (3) contradicting? Actually, it seems that statement (1) and (3), although both are talking about the numerator (market value of the company) of Tobin’s q, it is giving different interpretation. (1) is saying if numerator is higher then you should invest in the company as the company will produce more out of the assets given. And what I think (2) is saying is that you should invest in undervalued companies because the numerator is lower than the denominator (replacement cost of its assets).
It is simple investing philosophy that one should discover an underpriced asset before the rest of the world does. Tobin Q would indicate that an investment is wise if the market has not yet realized that a company assets are undervalued , as indicated by a low market capitalization ( i.e. its shares are selling in the market at a price lower than its ( A-L) would indicate. If an investor would buy into such underpriced shares , then when the fundamentals become more exposed to general public , they are going to bid up the shares , thus benefitting the early birds. The suppliers of the firms are the ones that will benefit from overvaluation. They do have a claim on the assets of the firm at a liquidation value , so their interests are better covered when assets are valuable or total liabilities are lower than assets. Investors of the common stock have the exact opposite viewpoint than suppliers
I think you also ned to take into consideration the difference between a good company and a good investment. If Tobin q is > 1 it could be interpreted as a good company based on adding value etc etc…but maybe not a good investment. If Tobin q<1 it could be a good investment because assets are undervalued.
I think there is difference between the additional investment (of capital) and buying existing equity or debt of a company from some other investor.
I have a question about the Tobin question. Who is Tobin?
Wikipedia: James Tobin (March 5, 1918 – March 11, 2002) was an American economist who, in his lifetime, served on the Council of Economic Advisors and the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He developed the ideas of Keynesian economics, and advocated government intervention to stabilize output and avoid recessions. His academic work included pioneering contributions to the study of investment, monetary and fiscal policy and financial markets. He also proposed an econometric model for censored endogenous variables, the well known “Tobit model”. Tobin received the Nobel Memorial Prize in Economic Sciences in 1981.
pfcfaataf Wrote: ------------------------------------------------------- > I think there is difference between the additional > investment (of capital) and buying existing equity > or debt of a company from some other investor. +10 You have hit the nail on the head…