The Q Ratio And Market Valuation: February Update

The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Financial Accounts of the United States, which is released quarterly.

The Q2 2019 release had significant revisions. Here is an explanation from the Fed:

"The upward revision to liabilities on the corporate balance sheet brings the U.S. Financial Accounts into closer alignment with the international standards in the System of National Accounts 2008. Because the revised measure of liabilities represents a broader definition than is typically assumed on corporate balance sheets, we have adjusted the debt- and equity-to-net worth ratios shown on table B.103 (lines 43 and 45) to exclude the equity portion of FDI."

You can read more regarding these revisions here by clicking on "Why did the net worth of the nonfinancial corporate business sector revise significantly downward with the 2019:Q2 publication?"

Extrapolating Q

The ratio subsequent to the latest Z.1 Fed data (through 2020 Q3) is based on a subjective process that factors in the monthly closes for the Vanguard Total Market ETF (VTI).

Unfortunately, the Q Ratio isn't a very timely metric. The Z.1 data is over two months old when it's released, and three additional months will pass before the next release. To address this problem, our monthly updates include an estimate for the more recent months based on changes in the VTI price (the Vanguard Total Market ETF) as a surrogate for Corporate Equities; Liability.

The first chart shows the Q Ratio from 1900 to the present.

Q Ratio

Interpreting the Ratio

The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.103, Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically, it is the ratio of Market Value divided by Replacement Cost. It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that "the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same."

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