The Tobin’s q Theory of Investment

UDDIN, GODWIN ENAHOLO

OCTOBER 2020

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 The Tobin’s q Theory of Investment

The Tobin’s q investment theory, whose background could be inferred from Kaldor (1966) and
which was later popularized by Tobin and Brainard (1976), provided a rationale through which
firms could explore asset markets (or capital markets) for their growth, and thence contribute to
real economic activity. More so, it is a concept that considers two variables: (1) the current price
of capital (current / liquid and non-current / fixed) assets owned by a firm and as measured by
accountants, and (2) the market value of equity and bonds attributable to same firm (Dimand,
2014).

In simple terms, the Tobin’s q, conventionally presented as a ratio, could be stated as follows;

q= firm’s net worth / firm’s shares value

Thus, from the above:

(a) If Tobin's q is greater than 1.0, then the market value of a firm’s equity (and bonds) is greater
than the value of the company's recorded assets. This suggests that the market value of the firm’s
equity (and bonds) reflects some unmeasured or unrecorded assets of the company. High Tobin's
q values encourage companies to invest more in capital because they are "worth" more than the
price they paid for them.

For example, if a company's stock price (which is a measure of the company's capital market
value) is N2 and the price of her capital in the current market is N1, so that q > 1, the company
can issue shares and with the proceeds invest in capital, thus obtaining economic profit.
(b) If Tobin's q is less than 1, the market value of a firm’s equity (and bonds) is less than the
recorded value of the assets of the company. This suggests that the market may be undervaluing
the company, or that the company could increase profit by getting rid of some capital stock,
either by selling it or by declining to replace it as it wears out.

Whereas, if the market value of a firm’s equity (and bonds) reflected solely (or exactly / equally)
the recorded assets of the company, Tobin's q would be 1.0.

Further insights on the Tobin’s q ratio reveal firms do not blindly base fixed investment
decisions on movements in the stock price (somewhat reflective of changes in consumption and
investment), rather they examine future interest rates and the present value of expected profits. In
specific amidst other examples, Blanchard, Rhee and Summers (1993) found with data of the US

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economy from the 1920s to the 1990s that “fundamentals” predict investment much better than
Tobin’s q, and what these authors call fundamentals is however the rate of profit which connects
these empirical findings with older ideas of authors such as Wesley Mitchell, or even Karl Marx,
that profits are the basic engine of the market economy.

Lastly, there are other elements recounted that may affect the value of q, namely: (i) market hype
and speculation (reflecting, for example, analysts' views of the prospects for companies, or
speculation such as bid rumors), and (ii) the "intellectual capital" of corporations (i.e. the
unmeasured contribution of knowledge, goodwill, technology and other intangible assets that a
company may have but aren't recorded by accountants ). To this end, Tobin's q is attested to be
also influenced by market hype and intangible assets so that we see swings in q around the value
of 1.

References

Blanchard, O., Rhee, C. & Summers, L. (1993). The stock market, profit, and investment.
Quarterly Journal of Economics, 108 (1): 115–136.
Dimand, R. W. (2014). James Tobin (Chap. 5; pp. 73 – 89). New York, NY: Palgrave Macmillan
Kaldor, N. (1966). Marginal productivity and the macro-economic theories of distribution:
Comment on Samuelson and Modigliani. The Review of Economic Studies, 33(4): 309 -
319
Tobin, J. and Brainard, W. C. (1976). Asset markets and the cost of capital. Cowles Foundation
Discussion Paper No. 427