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Evan Davis on... Tobin's Q

Updated Saturday, 21st March 2009

After The Bottom Line looked at share prices, Evan Davis explained the economic theory behind share prices: but can we believe Tobin's Q?

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Evan Davis: It's interesting to ask whether the price of a share in a company - whether it matters much to that company. Now, it matters to the chief executive. Sometimes, if the price goes very low, it means the company will be taken over; and sometimes, if the price goes very high, it means the company is about to be taken over, so it tells the chief executive of the company something about their company.

Now, in economics - financial economics, there’s a whole theory around why the share price should matter to a company. There’s a theory and a practice, and it's worth understanding the theory before looking at the practice. The theory comes down to a number called "Tobin’s Q". Now what that looks at is the ratio or the value of the company as measured by its shares and the value of the company as measured by all the bits in it, the kit. How much it would cost if you like to buy the company if you bought it off the shelf from scratch; if you bought the car, the machinery, the plant, all the other bits and bobs.

And the theory goes like this. It says, if Tobin’s Q, the ratio of these numbers, if Tobin’s Q is above one, it means that the share price of the company is bigger than the cost of buying the company off the shelf and recreating it. That would mean the stock market is telling you these companies are valuable and more of them should be recreated. If you can recreate a lot of these companies you could sell it on the stock market for more than the cost of simply recreating it.

So when Tobin’s Q is above one, the theory goes, when the share price is high, companies should be investing. They should be expanding. They should be replicating themselves. New entrants should be coming in trying to replicate the success of the high share price company. That’s the theory, it's Tobin’s Q. It's very interesting, it's worth reading about, but the interesting thing is, when you talk to company executives, it's not the thing that seems to be highest in their mind.

Yes, the share price affects sentiment. Yes, it affects their thoughts about investment but, in practice, it doesn’t quite - in the sort of precision-guided way of the economic theory - doesn’t really tell them how much investment to be engaging in. But it is still worth understanding the theory in order to know how good the practice is.

 

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