Theory of Tobin’s q: Concept, Implications and Factors | Investment Function

Let us make an in-depth study of the Theory of Tobin’s q. After reading this article you will also learn about: 1. Concept of Tobin’s q 2. Implications of Tobin’s q 3. Factors of Tobin’s q.

Concept of Tobin’s q:

Stock market fluctuations cause investment fluctuations.

Stock prices are high when firms have various profitable investment opportunities.

The reason is that these profit opportunities mean higher future income for the shareholders. This means that the incentive to invest gets reflected in stock prices.

According to James Tobin, who did a lot of original work on the financial market, suggested that firms’ decision to invest depends on the following ratio, called Tobin’s q:

If q is greater than 1, then economy’s installed capital is valued more highly by the stock exchange than its market price or its replacement cost.

In this case it is possible for firms to raise the market value of their stocks by buying more capital. In the converse case, where q is less than 1, it will not be judicious on the part of managers to replace capital or they will simply allow it to depreciate since the stock market values capital at less than its replacement cost.

Tobin’s q depends on current and future expected benefits from installed capital. If MPK exceeds the real cost of capital, firms are able to make profits on installed capital. As a result rental firms become desirous of owning capital.

This will raise the market value of stocks of the profit-making firms. The converse is true for firms incurring losses on their installed capital. For such firms since MPK is less than the cost of capital, the market value of installed capital is low, implying a low value of q, too.

Thus Tobin’s q as a measure of the incentive to invest has one major advantage. Both current and expected future profitability of investment get reflected in it. For example, if the Central Government of India announces a tax cut from the beginning of the next year, the expected profits for the owners of capital will be high.

This will raise the value of stock immediately, raise Tobin’s q and, therefore, encourage business managers to make more investment now. This means that investment decision depends not only on current economic policies but also on future economic policies, such as expected fall in the corporate tax rate early next year.

The following relation exists among gross investment relative to the capital stock (I/K), the q ratio, the average price of capital goods (j) and the ratio of replacement investment to the capital stock (d):

I/K = j[q – l] + d …(8)

Thus the I/K ratio is equal to d when Tobin’s q is unity. If d = 0.1 and j = 0.2, then I/K would be 0.1 and q equals unity. I/K would rise to 0.2 when q equals 1.5 and I/K would fall to zero when q equals 0.5.

Implications of Tobin’s q:

There are two important implications of Tobin’s q theory:

1. Valuation of Corporate Profits:

Since the most important source of movement in q is the change in stock market prices, Tobin’s theory creates an additional channel by which changes in the stock market may influence the economy through its effect on the attractiveness of investment.

Tobin’s theory also makes a major breakthrough in the area of investment behaviour. There is no need to guess how business firms make calculations about their expected future profits and how these expectations respond to economic events. Instead one has simply to look to the stock and bond markets for the necessary valuation of the firm’s future stream of profits.

2. Absence of Time Lag:

A notable feature of Tobin’s approach presented by equation (7) is that there are no lags in the equation. Thus, if the stock market drops by 20%, the I/K ratio would drop immediately by an amount that depends on the size of j.

Factors of Tobin’s q:

Empirical studies have not supported Tobin’s theory. Evidence shows that investment depends not just on the current value of the stock market (in the numerator of q), but also several lagged values as well. 

In addition, other variables, especially changes in output, the key variable in the accelerator theory, enter significantly into the explanation of I/K, thus contradicting the Tobin theory as captured by eqn. (8) which states that all informa­tion relevant to the investment decision is summed up by the market value of the firm.

In recent years, economists have made several attempts to isolate the factors that make Tobin’s q theory.

(i) Marginal q Versus Average q:

Tobin’s theory posits that investment should be made when the change that it creates in the firm’s market value exceeds its cost. The change in market value relative to capital cost is called ‘marginal q’ and can differ from the level of the market-value-to-cost ratio, called ‘average q’, on which data are available for statistical tests.

The possibility of differences between the theoretical concept of marginal q and data available on average q is very important in the real world, where there are many different types of capital.

(ii) Ordering and Delivery Lag:

There is an ordering and delivery lag that intervenes between the time a firm decides that a new investment expenditure is profitable and the time the investment good is delivered.

(iii) Imperfections in Capital Market:

There can be imperfections in capital markets. That is why every firm does not raise the capital to finance its investment in the stock or bond markets. Some borrow from banks and others lease much of their capital equipment from other firms.