Definitions

# Tobin, James

Tobin, James, 1918-2002, American economist, b. Champaign, Ill., Ph.D. Harvard, 1947. A professor at Yale Univ. from 1950 until his death, he was also an influential member (1961-62) of President Kennedy's Council of Economic Advisers. Tobin's work advanced the significant "portfolio theory," which holds that diversification of interests offers the best possibility of security for investors, and that investments should not always be based on highest rates of return. He also wrote on the process of information exchange between financial markets and "real" markets. Tobin was awarded the Nobel Memorial Prize in Economic Sciences in 1981.
Tobin's q is a ratio comparing the value of a company given by financial markets with the value of a company's assets. The ratio was developed by James Tobin (Tobin 1969). It is calculated by dividing the market value of a company by the replacement value of its assets:

Tobin's q = $frac\left\{text\left\{market value\right\}\right\}\left\{text\left\{asset value\right\}\right\}$

Another use for q is to determine the valuation of the market as a whole. The formula for this is: $q=frac\left\{text\left\{value of stock market\right\}\right\}\left\{text\left\{corporate net worth\right\}\right\}$

## Application

If the market value reflected solely the recorded assets of a company, Tobin's q would be 1.0.

If Tobin's q is greater than 1.0, then the market value is greater than the value of the company's recorded assets. This suggests that the market value reflects some unmeasured or unrecorded assets of the company. High Tobin's q values encourage companies to invest more in capital because they are "worth" more than the price they paid for them.

$q = frac\left\{text\left\{Market value of installed capital\right\}\right\}\left\{text\left\{Replacement cost of capital\right\}\right\}$

If a company's stock price (which is a measure of the company's capital market value) is £2 and the price of the capital in the current market is £1; the company can issue shares and with the revenue invest in capital. In this case q>1.

On the other hand, if Tobin's q is less than 1, the market value is less than the recorded value of the assets of the company. This suggests that the market may be undervaluing the company.

Lang and Stulz found out that diversified companies have a lower Q-ratio than focused firms because the market penalizes the value of the firm assets.

Tobin's discoveries show us that movements in stock prices will be reflected in changes in consumption and investment. Although empirical evidence reveals that his discoveries are not as tight as one would have thought. This is largely because firms do not blindly base investment decisions on movements in the stock price rather they examine the present value of expected profits and future interest rates.

## Variables

Tobin's q reflects a number of variables, and in particular:

• The recorded assets of the company.
• Market sentiment, reflecting, for example, analysts' views of the prospects for the company, or speculation such as bid rumors.
• The intellectual capital of the company.

Since Tobin's q reflects a number of variables it can only be an approximation of the value of intellectual capital. Many companies now seek to develop ways to measure intangible assets such as intellectual capital. See balanced scorecard.

## Tobin's marginal q

Tobin's marginal q is the ratio of the change in the value of the firm to the added capital cost for an increment to the capital stock.

## P/B ratio

In inflationary time, Q will be lower than P/B ratio, conversely it will be higher than Q.

## Criticism

Doug Henwood, in his book Wall Street, argues that the q ratio fails to accurately predict investment, as Tobin claims. "The data for Tobin and Brainard’s 1977 paper covers 1960 to 1974, a period for which q seemed to explain investment pretty well," he writes. "But as the chart [see right] shows, things started going away even before the paper was published. While q and investment seemed to move together for the first half of the chart, they part ways almost at the middle; q collapsed during the bearish stock markets of the 1970s, yet investment rose." (p. 145)

## Notes

• Tobin's q is sometimes written as "Tobin's-q", "Tobin's Q" or simply Q. It is also called Tobin's Quotient, since the Q stands for Quotient.

## Sources

• Tobin J. (1969) "A general equilibrium approach to monetary theory", Journal of Money Credit and Banking, Vol 1No 1 pp 15-29
• Smithers, Andrew; Wright, Stephen (2000). Valuing Wall Street: Protecting Wealth in Turbulent Markets. McGraw-Hill. ISBN 0-07-135461-1

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