Tobin's Q

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Definition

Our approximation of Tobin's Q is based on research by Chung and Pruitt in http://www4.fe.uc.pt/jasa/m_i_2010_2011/asimpleapproximationsoftobinsq.pdf. Calculations of Tobin's Q is known to be difficult because of the formula components of preferred stock, valuations of its long term debt, and net capital stock.

A pure Tobin's Q represents the ratio between market value and replacement value of the same physical asset. Normally, this ratio is used as an economic indicator as an example of over/under valued stock markets.

Tobin's Q for individual companies is thought of as the (market value of equity and liabilities) / (book value of equity and liabilities). Obtaining the book value for equity and liabilities is generally easier than getting the market valuation due to changes in daily market valuations (ie. How would one easily get the market value of a firm's long-term and preferred debt? How should one think about a company's default risk and overall interest rates in the market valuation of debt?)

Chung and Pruitt in their research noted that an approximation of Tobin's Q could be made as an "approximate Q" where an approximate Q is made with market cap, preferred stock, short term liabilities without short term debt, and total assets. Results from a series of regressions from Chung and Pruitt's model "indicate that at least 96.6% of the variability of Tobin's q is explained by approximate q." Chung and Pruitt use the market value of market capitalization, preferred stock, and short-term liabilities (without short-term assets) over the total assets of a firm. Preferred stock and short-term liabilities often trade at par in normal market situations.

Note : Usage of Tobin's Q for companies with a high chance of default should not be used here because market valuations of preferred stock and short-term liabilities significantly differ than book value valuations. In normal market situations, both preferred stock and short-term

Formula

Approximate q = (Market Cap + Value of firm's outstanding preferred stock + Value of firm's short-term liabilities net of short-term assets) / Total Assets (Book Value of Total Assets of the Firm).

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