March 31, 2009
At the close of 2008, with US markets approximately 10% higher than their current levels, PIMCO CIO Bill Gross proclaimed that “today’s Q ratio has almost never been lower, and certainly not since WWII, implying extreme undervaluation…”
At the same time, Russell Napier, a strategist at CLSA, a leading international brokerage and investment firm, said Q ratio values supported his expectation of a “horrific” market bottom and further 55% drop in the S&P 500 Index by 2014.
So who is right?
As with most broad-based valuation tools, the Q ratio does not provide uniform and unambiguous guidance to investors. Understanding its derivation and methodology, however, leads to important insights about economic and market trends.
The Q ratio was developed in 1969 by the late economist and Nobel laureate James Tobin, and the metric is often referred to as Tobin’s Q. It measures the market value of a company (i.e., its stock price) relative to the replacement cost of its assets. A value greater than one indicates that a company’s assets could be purchased more cheaply than the company itself and, hence, the market is overvaluing the company, while Q ratios less than one indicate market undervaluation.
John Mihaljevic, a former research assistant of Tobin’s and a leading expert on the Q ratio, writes the Equities and Tobin’s Q, a quarterly publication with his own estimate of the Q ratio and its implications for investors.
Mihaljevic is “modestly bullish” based on the current Q ratio of 0.43.
Calculating the numerator for the market’s prevailing Q ratio is relatively straightforward, since it equals the market value of the equity and debt of the companies that comprise the S&P 500, less net liquid assets and land value. Calculating the denominator, however, is much more problematic. The replacement value of assets is inherently subjective and can, at best, be estimated. Mihaljevic uses Federal Reserve data to calculate the replacement value of structures, equipment, software, and inventory.Looking at Mihaljevic’s historical data, it is easy to see why Gross believed the market was undervalued:
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