Is the Stock Market Overpriced? Part III

Way back in 1968 (before many of you readers were born) when Robert Shiller was still getting his Master’s at MIT, a man named James Tobin published a rationalization for market valuation with his partner William Brainard.

Tobin was an Economist of the Keynesian variety, and a supporter of Government intervention to spur economic growth.  His fame came from the so-called “Tobit Model“, a model he published in 1958 which could be used to calculate a relationship between two variables.  He also was known for suggesting the “Tobin Tax” on foreign exchange transactions.  He won the Nobel Prize in 1981.

Today, however, we toss him into focus because like our friends Shiller and Buffet, he and Brainard had a useful model for market valuation – known today as Tobin’s Q.

See Part I – Robert Shiller

See Part II – Warren Buffett

See Part III – James Tobin

See Part IV – Main Street

See The Finale – What Does it Mean?

Back in the Ivory Tower

In this series we’ve whip-lashed between the Ivory Tower and Wall Street – or at least Yale and Omaha.  Tobin’s method brings us back to Academia, but thankfully to a ratio with an impressive history.  While it’s important to note that the q can be applied to individual firms, as a valuation metric it is (obviously) best applied to the stock market as a whole.

Have you ever had a home appraised?

One of the valuation metrics used to value homes is the so-called cost of replacement.  Tobin’s q is a rough approximation of whether a company (or, for our purposes, companies) is being priced at more or less than it would cost to replace.  For the purposes of market valuation, the Federal Reserve Board of Governors publishes everything we need, as represented by this fraction:

Nonfarm Nonfinancial Corporate Business Equities and Liabilities

________________________________

Nonfarm Nonfinancial Corporate Business Net Worth

Tobin’s q

Here’s how the q looks going back to the 40s:

Tobin's q Using FRED Data

(Links to the 2 series are in the quote box above).

All time, the average Tobin q is ~ .693 and the median is ~.714.

The most recent q?  .92

So It’s Overpriced?

Of the three ratios we’ve looked at so far, the stock market is most obviously ‘overvalued’ by Tobin’s q.  Remember, what we’re trying to do here is basically figure out what people are paying for a company (based on liability and equity prices) versus the net worth of the company.  You’ll note that since the early 90s, the q has become elevated – only once flashing a buy signal (between 3Q 2008 and 2Q 2009 q never went above .716).

That could mean a few things, but one theory is the most interesting – perhaps net worth is understated?

Goodwill is a measure that companies hold on their books which attempts to balance the intangibles of a company often due to mergers and acquisitions in the market.  However, there are a few other things which might be considered assets, without GAAP agreeing: ‘brain trust’ or amazing talent at the firms, or perhaps assets held at purchase price instead of fair value.  Or (and here is an interesting one): political effects or barriers to entry which make it so companies already in the market can keep out new competition.

Let’s hope it’s not the last one, eh?

The Final Word

Sadly, we can’t ask Professor Tobin – he passed away back in 2002.  However, I did find an interesting piece in the New York Times from 1996 estimating Q for the S&P 500 at around 1.4 to 1.5.  If you had sold then?  Well, you would have missed the Tech Bubble.

However, q is still historically high, and an interesting ratio for your toolbox.  Use it in good health.

 

Comments

  1. JT says

    Accounting complexities and economics pretty much make the Tobin Q unfit for use. As you mentioned, goodwill is something that has changed in just the past few years. Used to be that it would amortize. Today, it’s checked for impairment. So it no longer naturally goes down over time. Just one of a billion accounting treatment changes over time. Tobin Q certainly catches the problem with real estate on a balance sheet. Held at cost, there is probably trillions of dollars in real estate valued in the billions on public company balance sheets.

    Then you have to make assumptions about what the economic return on public company book value should be, or is. I mean, if you’re only earning 2% per year on your book value, you should probably be priced at 1/5th of book value (to get a 10% return.) Just because stocks are selling at 40% of book value doesn’t necessarily make them a bargain, nor is 3x book value a bad price. Altria has always sold at a huge premium to book (currently 19x) but it has been one of the best investments ever. Obviously intangibles like the brand, addictive qualities of its products, and distribution advantages aren’t on the balance sheet.

    I think it’s interesting, no doubt. Useful? Meh. I’m not so sure. I still think value is something that will never, ever be identified quantitatively from the top down. Though it will be tried and argued over and over. Thanks for an interesting post. Lots of food for thought here.

    • says

      I’m not sure with your conclusion – I doubt that valuation from a top down perspective will ever match the valuation of single companies, but I look at it as one of those “a rising tide floats all boats” sort of things. An undervalued company eventually needs a catalyst to start rising, and in an overvalued market I wonder how many investors could stream in. I’d rather believe the market as a whole had ‘value’ because I would then believe people could stream in and validate my hypotheses. Could work?

Trackbacks