Definition - What does Q Ratio mean?
The Q ratio is used to estimate the fair value of a stock market. It is calculated as the total price of the market divided by the replacement cost of all the companies that trade in it. Though this looks hard to calculate, in reality it is not because the federal government gives the numbers needed to make this calculation. It publishes these numbers in the publication titled, "Federal Reserve Z.1 Financial Accounts of the United States." This information is released once every quarter.
Divestopedia explains Q Ratio
The Q ratio, also known as Tobin's Q, was developed by Nobel Laureate James Tobin. Besides evaluating the value of a stock market, it is also used to measure the assets of an organization in relation to its market value. It is calculated as:
Tobin's Q = Total market value of the organization / Total asset value of the organization
For example, if an organization has 10 million shares outstanding, a current share price of $10 per share and $50 million in assets, then
Tobin's Q = (10,000,000 X 10)/$50,000,000 = 2
The idea behind this ratio is to hypothesize the value of an organization or stock market when it is time to replace it. In general, when the Q ratio is between 0 and 1, it costs more to replace the assets of the organization than what the organization is worth. When the Q ratio is more than 1, then it means that the organization is worth more than the value of its assets. The same theory applies to stock markets.
A practical application of Tobin's Q ratio is to determine whether an organization is overvalued or undervalued. When this ratio is more than 1, it means the organization or stock market is overvalued. In the case of a stock market, it also means that a crash is likely to happen because the stock market is overvalued. In the case of an organization, a higher Q ratio means that the share price or market value of that organization is high for its fundamentals. Hence, a decline in its share price is imminent.
Although this term is not directly applicable to a private company in the middle market, it can be a useful ratio to assess fair market value of a company versus its asset value.