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Investment Strategy
Thursday, January 1, 2009
A mean idea

One long range valuation tool is the so-called ‘Tobin Q ratio’, which was developed by the late James Tobin in 1969. It measures the value of listed shares with the value of company’s equity book value or the replacement value of the net assets. It’s similar to the price to book ratio, but instead looks at the replacement value of assets.

Explains Ian de Lange, of Seed Investments, “The ratio is calculated by dividing the market value of a company by the replacement value of the book value. The logic behind the ratio is that where the Q ratio is above 1, then the market is valuing a company at more than it costs to reproduce it and stock prices should decline.
“Conversely where the Q ratio is below 1, it is indicating that shares are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market.”
As with many indicators, in the shorter run they tend to be volatile and not very useful. But looking back over longer periods of time, it’s apparent that such a ratio must be mean reverting around 1. As Pimco’s Bill Gross noted, “As long as capitalism is a going concern, Q should mean revert to 1.”
Notes De Lange, “this ratio indicates that equity relative to replacement cost was cheap in the late 1970s to mid 1980s. Then in the mid to late 1990s equity relative to replacement cost started getting expensive. This normalised from around 2000. But with equity prices now tumbling sharply, the value of equity relative to the replacement cost is once again cheap.
“The 1990s were the time for private business owners to list their equity at premiums. Existing private equity owners will now not find it attractive to list equity, while the market itself won’t be receptive to new listings.
“Rather we are entering into a time, when larger entities, private equity players and management will find bargains in listed equity and look to buy them in management buy outs.”

Copyright © Insurance Times and Investments® Vol:22.1 1st January, 2009
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