Q ratio is a method of measuring publicly traded companies in an effort to predict their stock market potential. Also known as Tobin's Q in honor of the economist who created the formula, Q ratio is reached by dividing a company's market value by the replacement value of all of the company's assets. A ratio higher than one suggests that a company is overvalued, while a ratio of lower than one is considered low and indicates that a company may be undervalued. This ratio is also often used to measure the market as a whole and signal to investors whether prices in general will be rising or falling.
James Tobin of Yale University, who was a Nobel laureate in the field of economics, developed the theory upon which the Q ratio is based. The concept of the replacement value of a company's assets is the key element to his theory. Essentially, the replacement value of the assets of a specific company is what it would cost to rebuild the company from scratch to the exact standing it has at the current time.
Taking this replacement value and dividing it into the company's total market value yields a company's Q ratio. Tobin theorized that the ratio for all of the stock market should be one because the market value should be determined by the assets of the companies within it. That isn't the case, however, which means that certain stocks are being regarded as higher than they should be, while others may not be getting the market attention they deserve.
If a company has a Q ratio greater than one, it means that its actual assets fall short of how highly investors regard the company itself. On the contrary, an undervalued company will have a ratio of less than one, meaning that the value of its assets outweighs the current stock price. These inefficiencies are caused by investors' reliance on intangible qualities, such as brand names, past experience, and customer loyalty, when making their decisions.
Investors also use the Q ratio to study the stock market as a whole. As the ratio was designed with the entire market in mind, it has proven in the past to be an accurate predictor of how the market will be trending shortly after it is calculated. The ratio for the entire market moves at an extremely slow pace, so investors who believe in its predictive powers take note any time that it shifts decisively one way or another.