Book Value, Market Value, and Tobin’s Q
Thebook valueof a firm has often been used as a valuation yardstick. The
book value is the value of a firm’s assets minus its liabilities, evaluated at
historical costs. The use of aggregate book value as a measure of the over-
all value of a firm is severely limited because book value uses historical
prices and thus ignores the effect of changing prices on the value of the
assets or liabilities. If a firm purchased a plot of land for $1 million that is
now worth $10 million, examining the book value will not reveal this.
Over time, the historical value of assets becomes less reliable as a meas-
ure of current market value.
To help correct these distortions, James Tobin, a professor at Yale
University and a Nobel laureate, adjusted the book value for inflation
and computed the “replacement cost” of the assets and liabilities on the
balance sheet.^27 He developed a theory that the “equilibrium” or “cor-
rect” market price of a firm should equal its assets minus its liabilities
adjusted for inflation. If the aggregate market value of a firm exceeds the
cost of capital, it would be profitable to create more capital, sell shares to
finance it, and reap a profit. If the market value falls below the replace-
ment cost, then it would be better for a firm to dismantle and sell its cap-
ital, or stop investment and cut production.
Tobin designated the ratio of the market value to the replacement
cost with the letter Q, and he indicated that its ratio should be unity if
the stock market was properly valued. The historical values of “Tobin’s
Q,” as the theory has become known, are shown in Figure 7-6. The ratio
has fluctuated between a high of 1.84 in 1999 to a low of 0.27 in 1920,
with the average being 0.70.
In 2000 Andrew Smithers and Stephen Wright of the United King-
dom published the book Valuing Wall Street,^28 which maintained that
Tobin’s Q was the best measure of value and that the U.S. markets as
well as the U.K. and many other European markets were extremely
overvalued by this criterion. There are some who maintain that Q
should generally be less than unity because older capital is not as pro-
ductive as newly installed capital.^29 If this is true, then the market was
even more overvalued in the late 1990s.CHAPTER 7 Stocks: Sources and Measures of Market Value 117
(^27) James Tobin, “A General Equilibrium Approach to Monetary Theory,” Journal of Money, Credit, and
Banking, vol. 1 (February 1969), pp. 15–29.
(^28) Andrew Smithers and Stephen Wright, Valuing Wall Street: Protecting Wealth in Turbulent Markets,
New York: McGraw-Hill, 2000.
(^29) This is also because in equilibrium the marginal productivity of capital should be treated as being
equal to the cost of new capital, while the stock market measures the average productivity of both
old and new capital.